., p. 37.
12 Ibid.
13 Speech available at http://www.federalreserve.gov/boarddocs/speeches/1996/ 19961205.htm.
He was speaking in the midst of a stock market bubble, and almost everyone feared it or knew it, including the Federal Reserve. On November 25, 1996, the Wall Street Journal had reported: “Federal Reserve Board Chairman Greenspan isn’t talking about the stock market these days. In fact, the word among Fed officials is: don’t use the words ‘stock’ and ‘market’ in the same sentence. No one wants the blame for the crash.”14 Two days later, the Bank for International Settlements (the central bankers’ central bank) warned about the “prevailing euphoria” in global credit markets.15
At the September 24, 1996, FOMC meeting, Greenspan said: “I recognize that there is a stock market bubble problem at this point. . . . We do have the possibility of raising major concerns by increasing margin requirements.

…

The act defined Neighborhood Reinvestment’s mission as “revitalizing older urban neighborhoods by mobilizing public, private and community resources at the neighborhood level.”
23 FOMC meeting transcript, July 2–3, 1996, p. 33.
CHAIRMAN GREENSPAN. On that note, we all can go for coffee.
Mr. Coffee escaped once again.26
Lindsey had summed up our future. His only error was timing. He did not—but who did?—predict that the stock market bubble would grow for 3½ more years. The stock market bubble forestalled a reckoning. That bubble concealed much that was wrong with a misaligned economy— specifically, the amount of borrowing required to boost the GDP.
The gambler’s curse did not strike for another 10 years. First, the stock market cured all that plagued the “real” economy. After that failed, Greenspan seeded a national housing carry trade.
“[T]he non-rich, non-old liv[ing] paycheck to paycheck”27 would live off the profits and collateral as the Dow rose from 5,000 to 11,000.

…

This was his ever-so-muted warning that the stock market might be overpriced: “how do we know when irrational exuberance has unduly escalated asset values?”
Yet, he claimed he had popped a bubble in 1994. “I think we partially broke the back of an emerging speculation in equities. We pricked that bubble [in the bond market] as well.”5 He offered to pop the bubble at the September 1996 FOMC meeting: “I recognize that there is a stock market bubble problem at this point. . . . We do have the possibility of raising major concerns by increasing margin requirements. I guarantee that if you want to get rid of the bubble, whatever it is, that will do it.”
After his “irrational exuberance” speech, Greenspan gave a couple of warnings in early 1997. Critics told him that he should not make stock market predictions. He never addressed the bubble again—that is, until he decided that he could not identify one before it blew up.

In Table 8.1, the main parameters of the ﬁts are given as well
as the beginning and ending dates of the bubble and the size of the
24000
1.0
’Argentina IV’
’Argentina IV’
Best fit
0.8
Spectral Power
26000
Index
22000
20000
18000
16000
0.4
0.2
14000
12000
0.6
95.5
96
96.5
Date
97
97.5
0
0
1
2
3
4
5
Frequency
6
7
Fig. 8.10. Left panel: The Argentinian stock market bubble ending in 1997. See
Table 8.1 for the main parameter values of the ﬁt. Right panel: Only the best ﬁt is
used in the Lomb periodogram. Reproduced from [218].
8
292
chapter 8
1.0
14000
’Brazil’
’Brazil’
Best fit
0.8
Spectral Power
Index
12000
10000
8000
0.6
0.4
0.2
6000
96.2
96.4 96.6 96.8 97
Date
0
97.2 97.4
0
1
2
3
4
5
Frequency
6
7
8
Fig. 8.11. Left panel: The Brazilian stock market bubble ending in 1997. See
Table 8.1 for the main parameter values of the ﬁt. Right panel: Only the best ﬁt is
used in the Lomb periodogram. Reproduced from [218].
crash/correction, deﬁned as
drop % =
Itmax − Itmin
Itmax
(16)
Here, tmin is deﬁned as the date after the crash/correction where the
index It achieves its lowest value before a clear novel market regime
is observed.

The stock-market bubble of the 1990s coincided with an explosion in financial news. Relative even just to a decade ago, investors now have access to vast troves of information about companies and the markets, thanks to the Internet and cable television. The most influential source of financial news in the late nineties was unquestionably CNBC. Fortune columnist Andy Serwer wrote in 1999, “I think CNBC is the TV network of our time . . . The bull market we’ve been basking in year after year has made investing the national pastime. The more stocks go up, the more of us get into the market, the more we watch CNBC to keep abreast of the action.” (Notice that Serwer’s description—“the more stocks go up, the more of us get into the market”—perfectly captures the logic of a stock-market bubble.) Seven million people a week watched CNBC at the market’s peak, and if you were at all interested in the stock market, it was inescapable.

…

Each of the chapters is devoted to a different way of organizing people toward a common (or at least loosely common) goal, and each chapter is about the way collective intelligence either flourishes or flounders. In the chapter about corporations, for instance, the tension is between a system in which only a few people exercise power and a system in which many have a voice. The chapter about markets starts with the question of whether markets can be collectively intelligent, and ends with a look at the dynamics of a stock-market bubble.
There are many stories in this book of groups making bad decisions, as well as groups making good ones. Why? Well, one reason is that this is the way the world works. The wisdom of crowds has a far more important and beneficial impact on our everyday lives than we recognize, and its implications for the future are immense. But in the present, many groups struggle to make even mediocre decisions, while others wreak havoc with their bad judgment.

…

Groups benefit from members talking to and learning from each other, but too much communication, paradoxically, can actually make the group as a whole less intelligent. While big groups are often good for solving certain kinds of problems, big groups can also be unmanageable and inefficient. Conversely, small groups have the virtue of being easy to run, but they risk having too little diversity of thought and too much consensus. Finally, Mackay was right about the extremes of collective behavior: there are times—think of a riot, or a stock-market bubble—when aggregating individual decisions produces a collective decision that is utterly irrational. The stories of these kinds of mistakes are negative proofs of this book’s argument, underscoring the importance to good decision making of diversity and independence by demonstrating what happens when they’re missing.
Diversity and independence are important because the best collective decisions are the product of disagreement and contest, not consensus or compromise.

That said, investors have short and selective memories. If the market advances from a low point to any significant
degree upward, buy and hold feels comfortable again. It can feel like market
bubbles are a thing of the past—especially when so many talking heads are
preaching recovery.
Buy and Hope
153
No one knows if there is a current bubble in stocks, but it is amazing that
some people think they know. I had a conversation with a friend recently. He
mentioned that real estate in Southern California was stabilizing (forget that
debate for a moment), and then the conversation of bubbles came up. He
quickly announced that we were not in a stock market bubble. I was amazed
at his confidence. Has there ever been a time when the majority knew they
were in the middle of a bubble? Bubbles are never clear until the dust settles.

He makes a cogent case for an out of control Fed and Congress,
but consider an excerpt from his recent letter:
“In hindsight, I frankly underestimated the willingness of investors to
believe that the underlying structural difficulties of the economy
(which still persist in my view) were so easily
solved by disabling fair-market accounting disRide the horse
closure and repeatedly violating the provisions of
in the direction
the Federal Reserve Act. In any event, it is my
job to not only defend capital, but to achieve
it is going.6
returns despite the recklessness that policy makers choose to pursue.”5
S y s t e m a t i c Tre n d F o l l o w i n g
43
Trend traders use an entirely different type of analysis not based on traditional reasoning. Trend followers do not have Hollywood narratives to
explain market bubbles on top of bubbles. A trend follower does not have to
know any of the things Hussman laments not knowing.
Buy things that have gone up
on the theory that they will
continue to go up; short things
that have gone down on the
theory that they will
continue to go down.7
Empty your mind. Be formless,
shapeless, like water. Now you put
water into a cup, it becomes the
cup. You put water into a bottle it
becomes the bottle.

During
the dot-com era of the late 1990s, during the 2008 real estate and
credit bubbles, so many investors and traders with so little strategy
were making so much money that trend followers disappeared from
the radar screen, even though they kept right on making money.
Since trend following has nothing to do with short-term trading,
cutting edge technologies, or Wall Street Holy Grails, its appeal is
always negligible during market bubbles. It’s not sexy. If investors
can jump on the bandwagon of practically any “long only” mutual
or hedge fund manager or turn a profit trading themselves by simply
buying Internet, energy, or real estate stocks and holding on to
them, what need would there ever be to adopt a strategy such as
trend following?
However, if we look at how much money trend followers have
made since assorted stock market bubbles have popped, trend
following becomes far more relevant to the bottom line. The
following chart (Chart 1.1) shows a hypothetical index of three
longtime trend following firms compared against the S&P stock
index.

…

If you don’t like losing, examine the strategy of the winners.
The performance histories of trend followers during the 2008
market crash, 2000–2002 stock market bubble, the 1998 LongTerm Capital Management (LTCM) crisis, the Asian contagion, the
Barings Bank bust in 1995, and the German firm Metallgesellschaft’s collapse in 1993, answer that all important question: “Who
won?”
“Have you heard any
rumors?”
Killian, perplexed, said
no.
“I think we’re bust.”
“Is this a crank call?”
Killian asked.
“There’s a really ugly
story coming out that
perhaps Nick Leeson has
taken the company
down.”9
126
Trend Following (Updated Edition): Learn to Make Millions in Up or Down Markets
Event #1: 2008 Stock Market Bubble and Crash
One reason for this
paucity of early
information is suggested
by the following part of
the term trend following.

At the other end of the political spectrum, the British chancellor of the exchequer, Philip Snowden, a fervent Socialist who had himself frequently predicted the collapse of capitalism, could write gushingly that Norman “might have stepped out of the frame of the portrait of the most handsome courtier who ever graced the court of a queen,” that “his sympathy with the suffering of nations is as tender as that of a woman for her child,” and that he had “in abundant measure the quality of inspiring confidence.”
Norman had acquired his reputation for economic and financial perspicacity because he had been so right on so many things. Ever since the end of the war, he had been a fervent opponent of exacting reparations from Germany. Throughout the 1920s, he had raised the alarm that the world was running short of gold reserves. From an early stage, he had warned about the dangers of the stock market bubble in the United States.
But a few lonely voices insisted that it was he and the policies he espoused, especially his rigid, almost theological, belief in the benefits of the gold standard, that were to blame for the economic catastrophe that was overtaking the West. One of them was that of John Maynard Keynes. Another was that of Winston Churchill. A few days before Norman left for Canada on his enforced holiday, Churchill, who had lost most of his savings in the Wall Street crash two years earlier, wrote from Biarritz to his friend and former secretary Eddie Marsh, “Everyone I meet seems vaguely alarmed that something terrible is going to happen financially. . . .

…

Stock market crashes and banking panics had always been closely linked in the pre-Fed world and many of the country’s past financial crises had emerged from Wall Street: 1837, 1857, 1896, and 1907. In his early days as a stockbroker, he himself had been a witness firsthand to the crash of 1896, and had been an active participant in restoring order after the panic of 1907.
But as an experienced Wall Street hand, he was quite aware of how difficult it was to identify a market bubble—to distinguish between an advance in stock prices warranted by higher profits and a rise driven purely by market psychology. Almost by definition, there were always people who believed that the market has gone too high—the stock market depended on a diversity of opinion and for every buyer dreaming of riches in 1925, there was a seller who thought the whole thing had gone too far. Strong recognized his own highly fallible judgment about stocks was a very thin reed on which to conduct the country’s monetary policy.

…

Nobody knows and I will not dare prophesy.” Given so much uncertainty, he was convinced that the Federal Reserve should not try to make itself an arbiter of equity prices.
Moreover, even if he was sure that the market had entered a speculative bubble, he was conscious that the Fed had many other objectives to worry about apart from the level of the market. He feared that if he added yet another goal—preventing stock market bubbles—to the list he would overload the system. Drawing a rather stretched analogy between the Federal Reserve and its various and conflicting objectives for the economy and a family burdened by many children, he ruminated, “Must we accept parenthood for every economic development in the country? That is a hard thing for us to do. We would have a large family of children. Every time one of them misbehaved, we might have to spank them all.”

Markets do not accurately discount all known fundamentals, but rather they overdiscount or underdiscount this information, depending on the market’s emotional environment, and indeed this is one of the sources of investing or trading opportunities.
A much more realistic model of how markets actually work is that prices are determined by a combination of fundamentals and emotions. The same exact set of fundamentals can lead to different prices given different emotional environments. The long history of market bubbles and crashes provides overwhelming empirical evidence that the “madness of crowds”14 can take market prices far beyond any rational level based on value and fundamentals and that market panics can result in precipitous price declines completely removed from any contemporaneous changes in fundamentals. There is a clear line from the Tulipmania of seventeenth-century Holland when “houses and lands were . . . assigned in payment of bargains made at the tulip-mart”15 to the huge demand for mortgage-based securitizations in the early 2000s when investors eagerly bought AAA-rated tranches of securitizations backed entirely by no-verification ARM subprime mortgages for the tiny yield premium they offered.

…

Right for the Wrong Reason: Why Markets Are Difficult to Beat
Advocates of the efficient market hypothesis are absolutely correct in contending that markets are very difficult to beat, but they are right for the wrong reason. The difficulty in gaining an edge in the markets is not because prices instantaneously discount all known information (although they sometimes do), but rather because the impact of emotion on prices varies greatly and is nearly impossible to gauge. Sometimes emotions will cause prices to wildly overshoot any reasonable definition of fair value—we call these periods market bubbles. At other times, emotions will cause prices to plunge far below any reasonable definition of fair value—we call these periods market panics. Finally, in perhaps the majority of the time, emotions will exert a limited distortive impact on prices—market environments in which the efficient market hypothesis provides a reasonable approximation. So either market prices are not significantly out of line with fair valuations (muted influence of emotions on price) or we are faced with the difficult task of determining how far the price deviation may extend.

…

Markets are traded by people, not robots, and people often react on emotion more than on information.17 The influence of emotion can cause irrational behavior and result in prices being much too high or low vis-à-vis an objective assessment of the fundamentals.
3. The arrival of new information is random. ASSUME TRUE
4. Changes in prices depend on new information. FALSE!
Price moves often lag the information.
Price moves often occur in the absence of new information (e.g., market bubbles and crashes where momentum feeds on itself).
5. Therefore you can’t beat the market. FALSE!
Prices can be significantly out of line with reasonable valuations.
Prices don’t move in tandem with information.
Some people are more skilled in interpreting information.
Why the Efficient Market Hypothesis Is Destined for the Dustbin of Economic Theory
Supporters of the efficient market hypothesis are reluctant to give up the theory, despite mounting contradictory evidence, because it provides the foundation for a broad range of critical financial applications, including risk assessment, optimal portfolio allocation, and option pricing.

For example, the Renaissance created such a boom in the market for art and architecture because Italian bankers like the Medici made fortunes by applying Oriental mathematics to money. The Dutch Republic prevailed over the Habsburg Empire because having the world’s first modern stock market was financially preferable to having the world’s biggest silver mine. The problems of the French monarchy could not be resolved without a revolution because a convicted Scots murderer had wrecked the French financial system by unleashing the first stock market bubble and bust. It was Nathan Rothschild as much as the Duke of Wellington who defeated Napoleon at Waterloo. It was financial folly, a self-destructive cycle of defaults and devaluations, that turned Argentina from the world’s sixth-richest country in the 1880s into the inflation-ridden basket case of the 1980s.
Read this book and you will understand why, paradoxically, the people who live in the world’s safest country are also the world’s most insured.

…

Chapter 4 tells the story of insurance; Chapter 5 the real estate market; and Chapter 6 the rise, fall and rise of international finance. Each chapter addresses a key historical question. When did money stop being metal and mutate into paper, before vanishing altogether? Is it true that, by setting long-term interest rates, the bond market rules the world? What is the role played by central banks in stock market bubbles and busts? Why is insurance not necessarily the best way to protect yourself from risk? Do people exaggerate the benefits of investing in real estate? And is the economic inter-dependence of China and America the key to global financial stability, or a mere chimera?
In trying to cover the history of finance from ancient Mesopotamia to modern microfinance, I have set myself an impossible task, no doubt.

…

Mania or bubble: The prospect of easy capital gains attracts first-time investors and swindlers eager to mulct them of their money.
4. Distress: The insiders discern that expected profits cannot possibly justify the now exorbitant price of the shares and begin to take profits by selling.
5. Revulsion or discredit: As share prices fall, the outsiders all stampede for the exits, causing the bubble to burst altogether.3
Stock market bubbles have three other recurrent features. The first is the role of what is sometimes referred to as asymmetric information. Insiders - those concerned with the management of bubble companies - know much more than the outsiders, whom the insiders want to part from their money. Such asymmetries always exist in business, of course, but in a bubble the insiders exploit them fraudulently.4 The second theme is the role of cross-border capital flows.

The answer appears to be no.”
Actually, the answer appears to be yes, and he knew all along what it was. He could have raised the market’s margin requirements, thereby reducing how much stock people could buy with borrowed money. Krugman reminds us that at the September 1996 meeting of the Federal Open Market Committee (F.O.M.C.), Greenspan told his colleagues, “I recognize that there is a stock market bubble problem at this point” and that it could be solved by “increasing margin requirements. I guarantee that if you want to get rid of the bubble, whatever it is, that will do it.” But he didn’t do it. Nor did he lobby behind the scenes against the huge capital gains tax cut of 1997, which fed the market with another torrent of investor money. Not only did he do nothing to tame the market, writes Stiglitz, “he switched to becoming a cheerleader for the market’s boom, almost egging it on, as he repeatedly argued that the New Economy was bringing with it a new era of productivity increases.”

…

That’s a big number, even by the standards of the U.S. economy; it’s equal to almost 40 percent of the growth in personal spending, and a nice compensation for the failure of the economy to generate new jobs at a vigorous pace. But since we’re saving nothing these days—the personal savings rate went negative in 2005 for the first time since the Great Depression—the cash had to come from abroad. Since 2001 U.S. foreign debt has increased by a stunning $2 trillion.
One thing can be said for the housing mania: It’s kept the economy afloat since the bursting of the stock market bubble in 2000. (Wall Street economists estimate that 40 to 50 percent of the growth in GDP and employment over the last several years has been driven by the housing boom.) When the dot-coms went up in smoke, Alan Greenspan’s Federal Reserve drove interest rates down to 1 percent to contain the economic fallout.
But that “cure” is what got the housing mania going; low inter est rates made borrowing irresistible, and the nation’s speculative spirits were diverted away from Wall Street and toward home sweet home.

…

Rubin defends his thesis by blaming the rising trade deficit on inflexible currency exchange with China and other Asian nations. Correct that and everything will be fine, he says. Further, he explains that the capital deficits in the Clinton years were actually a good thing because the high-tech investment boom was drawing in more foreign investors. He neglects to mention that the boom included the high-tech stock-market “bubble” that collapsed a year later on George W. Bush’s watch, with $6 trillion in losses for investors. In any case, Rubin sees nothing in the trading system itself that needs fixing. “Maybe I’m missing something,” he says,
“but I don’t think there’s anything in the design of the system we would have done differently.”
Another debatable tenet in Rubin’s thinking is the familiar mantra that more education will save us in the long run—that is, improving Americans’ skills and knowledge will offset the low-wage competition.

This was a sizable
decline, but three weeks later the Dow had retraced its steps to the pre-9/11
level. Or go back to the assassination of President John F. Kennedy in 1963
or the bombing of Pearl Harbor in 1941. Given the scope of the tumult, the
market reactions to each event amounted to little more than a hiccup.
There is another troublesome facet to our modern market crises:
They keep getting worse. Two of the great market bubbles of the past century occurred in the last two decades. First, the Japanese stock market
bubble, in which the Nikkei index tripled in value from 1986 through
early 1990 and then nearly halved in value during the next nine months.
The second was our own Internet bubble that witnessed the NASDAQ rise
fourfold in a little more than a year and then decline by a similar amount
the following year, ultimately cascading some 75 percent.
This same period was peppered with three major currency disasters:
the European Monetary System currency crisis in 1992; the Mexican peso
crisis that engulfed Latin America in 1994; and the Asia crisis, which
spread from Thailand and Indonesia to Korea in 1997, and then broke out
of the region to strike Russia and Brazil.

…

In an age in which people are willing to invest money in virtual stocks,
where by definition there are no prospects of earnings and where price appreciation is obtained through nothing short of an unsustainable bubble,
it is not too hard to see how a real dot-com, with real prospects, no matter
how dim, could attract investors.
Market bubbles have been explained by the tendency of investors to
follow trends and by the dynamics of crowd psychology—the need for people to be part of a successful herd. But neither trend-following strategies
nor irrational crowd behavior is necessary to create market bubbles. Even
if we assume as a starting point that the stock market is a random walk and
168
ccc_demon_165-206_ch09.qxd 7/13/07 2:44 PM Page 169
T H E B R AV E N E W W O R L D
OF
HEDGE FUNDS
is governed by rational behavior, and even if we assert at the outset that all
trades reflect the full consideration of the most up-to-date information,
merely the fact that there are winners and losers will lead to booms and
busts that have little to do with the rational application of information.1
The simplest market cycle is based on two psychological characteristics
of investors.

…

If
it is Internet stocks in the late 1990s, the pundits point out that the information age is based on a new paradigm of value that is not well captured
by traditional methods of accounting and the related modes of fundamental analysis.
What has really changed is not the basic information—a P/E ratio is a
P/E ratio—but the implications derived from it. Taken in its most extreme
form, when there is a story that can afford unbridled optimism and when
the optimism is fueled by levered exposures, a market bubble is born.
In the case of the Internet bubble, the cycle had an accomplice in the
form of a restricted supply of stock, or float. The scarcity of Internet shares
was such that the market impact of each buyer contributed more than
usual toward inflating the bubble. The float of a stock is the number of
shares actually in the market and available for trading. Frequently, when a
stock first comes into the market, some of the shares outstanding are restricted from sale, either because they are held by insiders or because they
have been issued to major backers with restrictions on their sale.

TABLE
10–1
Compound Annual Dollar Returns in World Stock Markets, 1970 through December 2006 (Standard
Deviations in Parentheses)
Country or
Region
World*
EAFE†
USA
Europe
Japan
19702006
19701979
19801989
19901999
20002006
10.81%
6.96%
19.92%
11.96%
4.65%
(17.07)
(18.09)
(14.59)
(13.94)
(20.76)
11.57%
10.09%
22.77%
7.33%
7.08%
(21.93)
(22.77)
(23.28)
(16.93)
(23.85)
10.84%
4.61%
17.13%
19.01%
2.45%
(17.10)
(19.01)
(12.52)
(14.39)
(18.35)
12.27%
8.57%
18.49%
14.50%
7.34%
(20.95)
(20.97)
(25.89)
(12.71)
(24.33)
11.47%
17.37%
28.66%
-0.69%
4.28%
(34.69)
(45.41)
(28.57)
(28.90)
(25.71)
*World = Morgan Stanley Capital International (MSCI) Value-Weighted World Index.
†EAFE is the MSCI index for Europe, Australasia, and the Far East.
CHAPTER 10 Global Investing and the Rise of China, India, and the Emerging Markets
165
These differences in returns emphasize the importance of maintaining a
well-diversified world portfolio.
The Japanese Market Bubble
The 1980 bull market in Japan stands as one of the most remarkable bubbles in world stock market history. In the 1970s and 1980s, Japanese
stock returns averaged more than 10 percentage points per year above
U.S. returns and surpassed those from every other country. The bull
market in Japan was so dramatic that by the end of 1989, for the first
time since the early 1900s, the market value of the American stock market was no longer the world’s largest.

His monetary policy ideas owed much to Irving Fisher. And since a mid-1970s stint as chairman of Gerald Ford’s Council of Economic Advisers, he had become adept at sensing the winds of political Washington.
Put all that together, and what emerged in the late 1990s was the world’s most prominent advocate for the idea that financial markets got things right. Greenspan was willing to accept that stock market bubbles could happen, but he also thought deregulation, globalization, and technological innovation were bringing about advances in economic productivity that the stock market might be sniffing out before the government’s economists had. After his brief dalliance with “irrational exuberance,” Greenspan went on to cite this putative productivity boom repeatedly in his speeches and congressional testimony.

…

It was true, to a point. Economic data later showed that there was a sustained boom in labor productivity (that is, workers produced more per hour worked) beginning in 1995. In the decade following Shiller’s 1996 forecast of stock market returns of “just about nothing,” actual returns were slightly under historical averages but decidedly positive.16
FORECASTING THE MARKET IS HARD, and stock market bubbles tend to have some basis in economic reality. But that doesn’t mean they aren’t bubbles, and can’t cause damage when they burst, which was really all that Shiller was trying to say. Orthodox finance scholars often seemed to bend over backward to miss this point. In 1991, professor and money manager Richard Roll—whose research in the 1980s had backed up Shiller’s claim that markets were excessively volatile—followed up a Shiller presentation on market swings with a response that is still cited by efficient market stalwarts:
I really wish Bob were right about markets being inefficient.

…

(Investors are not simple rational actors/You can’t explain with your fancy three-factors!/Bad news, when the markets are on fire,/Gonna make me some money, can’t call me a liar/Sweet Emotion/Sweet Emotion.)
After all the singing was done, the two knocked each other out. “With no clear winner tonight, the debate rages on,” the fight announcer declared.1 Yes, even after the deflating of the 1990s stock market bubble, even in the face of reams of new evidence and theory on the craziness of financial markets, students at Chicago still saw the debate over market rationality as a stalemate. On the other hand, at least they knew there was a debate. And they could take classes with Dick Thaler.
BY THE TIME THALER MOVED to Chicago from Cornell in 1995, he was well known among economists. One key reason was the regular column he wrote for the Journal of Economic Perspectives, a publication launched in 1987 by the American Economic Association to keep increasingly specialized economists up to date on developments in the far corners of the discipline.

The Persistence of Error
PART TWO - The New Way
CHAPTER VI - Turbulent Markets: A Preview
Turbulent Trading
Looney ’Toons for Brown-Bachelier
Preview of More Close-Fitting Cartoons
CHAPTER VII - Studies in Roughness: A Fractal Primer
The Rules of Roughness
A Dimension to Measure Roughness
Pictorial Essay: A Fractal Gallery
CHAPTER VIII - The Mystery of Cotton
Clue No. 1: A Power Law Out of the Blue
Clue No. 2: Early Power Laws in Economics
Clue No. 3: The Laws of Exceptional Chance
The Cotton Case: Basically Closed
The Dénouement
The Meaning of Cotton
Coda: Looney ’Toons, Reprised for Long Tails
CHAPTER IX - Long Memory, from the Nile to the Marketplace
Abu Nil
Father Time
A Random Run
The Selling of H
Coda: Looney ’Toons of Long Dependence
CHAPTER X - Noah, Joseph, and Market Bubbles
An Alien Plays the Market
Two Dual Forms of Wild Variability
A Good Reason for “Bubbles”
CHAPTER XI - The Multifractal Nature of Trading Time
Looney ’Toons for the Last Time
Multifractal Time
Beyond Cartoons: The Multifractal Model with No Grids
Putting the Model to Work
PART THREE - The Way Ahead
CHAPTER XII - Ten Heresies of Finance
1. Markets Are Turbulent.
2. Markets Are Very, Very Risky—More Risky Than the Standard Theories Imagine.
3.

…

To me, all the power and wealth of the New York Stock Exchange or a London currency-dealing room are abstract; they are analogous to physical systems of turbulence in a sunspot or eddies in a river. They can be analyzed with the tools science already has, and new tools I keep adding to the old ones as need and ability allow. With these tools, I have analyzed how income gets distributed in a society, how stock-market bubbles form and pop, how company size and industrial concentration vary, and how financial prices move—cotton prices, wheat prices, railroad and Blue Chip stocks, dollar-yen exchange rates. I see a pattern in these price movements—not a pattern, to be sure, that will make anybody rich; I agree with the orthodox economists that stock prices are probably not predictable in any useful sense of the term.

…

Thinking in terms of the Nile, a record of floods that shows a sequence of mostly wet periods interspersed with brief droughts—or the opposite. Thinking in terms of prices, a long sequence of periods of growth with brief downswings—or the opposite. A value of H smaller than one half, shown on the top panel, has strong “anti-persistence”: Successive changes tend to cancel each other out. Again, the power of fractals shows a strange connection among seemingly unrelated phenomena.
CHAPTER X
Noah, Joseph, and Market Bubbles
I will cause it to rain upon the earth forty days and forty nights; and every living substance that I have made will I destroy from off the face of the earth.
Genesis 7: 4.
What God is about to do he showeth unto Pharaoh. Behold, there come seven years of great plenty throughout all the land of Egypt: and there shall arise after them seven years of famine; and all the plenty shall be forgotten in the land of Egypt; and the famine shall consume the land.

But—and this is important—that pain will be much more severe if borrowing fueled the bubble. Debt magnifies these recessions. When a recession follows a bubble that is not fueled by debt, five years later the economy will be 1 to 1.5 percent smaller than it would have been, if the bubble had never occurred. However, if the bubble is debt driven, the losses are worse. In the case of a stock market bubble fueled by debt—meaning investors were borrowing heavily to buy stock—the economy five years later will be 4 percent below its previous trend. A debt-fueled housing market bubble will have an even uglier endgame, with the economy shrinking as much as 9 percent compared with where it otherwise would have been, five years on.
The need to keep an eye on asset price inflation is particularly important in 2015, when many economists are warning that the world faced the opposite concern: Japan-style deflation.

…

Often a crash in prices of houses or stocks will depress the economy, because when those asset prices fall sharply, the result is a real decline in wealth. When people feel less wealthy, they spend less, resulting in lower demand and a fall in consumer prices as well. In other words, asset price crashes can trigger bouts of bad consumer price deflation.
This is what happened in Japan, where the real estate and stock market bubbles of the 1980s collapsed in 1990 and led to the long fall in both asset and consumer prices. It is also what happened in the United States during the Roaring Twenties, when the runaway optimism of the age drove up stock prices by 250 percent between 1920 and the peak in 1929. Then the market crashed and was followed by consumer price deflation in the early years of the Great Depression.
The key question for our purposes: When do rising asset prices reach the bubble stage and start to threaten economic growth?

…

Taylor, who researched 170 years of data for seventeen countries and demonstrated how the impact of housing bubbles has grown and spread.11 Before World War II, only seven of fifty-two recessions followed the collapse of a bubble in the stock market or the housing market. This link has tightened dramatically since World War II, with forty out of sixty-two recessions—nearly two-thirds—following on the heels of a collapse in the housing or the stock market.
The paper offered a number of benchmarks for understanding the likely fallout from these bubbles. In general, housing bubbles took longer to reach a peak than stock market bubbles, largely because stock prices are more volatile than home prices. Housing bubbles were much less common than stock price bubbles, but when they did occur, they were much more likely to be followed by a recession. And once prices for either houses or stocks rise sharply * above their long-term trend, a subsequent drop in prices of 15 percent or more signals that the economy is due to face significant pain.

Following Graham’s advice is easier said than done. During bull markets, less kindly known as bubbles, Mr. Market shows up every day quoting sky-high prices that only seem to go up. Most investors find it impossible to ignore the siren song. How could Mr. Market be so very wrong, day after day?
As early as 1982, Stanford economist Kenneth Arrow identified Tversky and Kahneman’s work as a plausible explanation for stock market bubbles. Lawrence Summers took up this theme in a 1986 paper, “Does the Stock Market Rationally Reflect Fundamental Values?” Summers (now head of the National Economic Council for the Obama administration) was the first to make an extended case for what might now be called the coherent arbitrariness of stock prices. From day to day the market reacts promptly to the latest economic news. The resulting “random walk” of prices has been cited as proof that the market knows true values.

The explanations the public got were that the authorities’ whir of activity would save the “financial system.” How the extension of more credit would ameliorate a crisis created by excess credit wasn’t explained. Also missing from the authorities’ explanations were examples of financial bubbles, once having popped, being successfully reinflated. No amount of intervention-ism has been able to reinflate the Japanese real estate and stock market bubbles that burst twenty years ago. Nor was there any clarity offered to explain why financial institutions that were incapable of sound operations should be preserved. The benefits to stimulus recipients were clear, but a holistic approach demands examination of not just benefits, but costs as well. The impact of the burgeoning debt on America’s creditworthiness and on the value of the dollar are among those costs.

…

It was good for the likes of Merrill Lynch, JPMorgan, and Chase Manhattan, which saw their depressed stock prices take off, but it had a costly impact on Americans. Driving rates to 3 percent by the time he was finished, Greenspan fundamentally altered the investment outlook and risk-taking proclivities of retired people and baby boomers alike, as they sought to make up in the stock market for the certificate of deposit and fixed income returns that had disappeared. Ultimately Americans lost $6 trillion in that Greenspan stock market bubble. But while the profits of the banks from market distortions are privatized, banking system losses, as we are wit nessing, are socialized. More alarming is the role of the central bank in funding wars not popular enough to be sustained by direct taxation. This function has been on display since the Federal Reserve Act of 1913 was first passed. Economist Murray Rothbard pointed out that the new act, which took effect in November 1914, coincided with the outbreak of World War I, so its inflationary capacity was put to the test right away:. . . it is generally agreed that it was only the new system that permitted the U.S. to enter the war and to finance both its own war effort, and massive loans to the allies; roughly, the Fed doubled the money supply of the U.S. during the war and prices doubled in consequence.

…

One need only remember the fabled Goldilocks economy of previous Federal Reserve chairman Alan Greenspan, the Maestro: “It was not too hot and not too cold, but just right!” Of course, Greenspan also admits he didn’t “get it” about the housing bubble until very late, in 2005 and 2006, despite home mortgage debt growing from $1.8 trillion to $8 trillion during his tenure. Nor did he foresee the stock market bubble before it popped in 2000. And he somehow missed the recession of the early 1990s. Greenspan’s successor, Ben Bernanke, didn’t get it either. As chairman of the President’s Council of Economic Advisers in October 2005, he told Congress that he wasn’t concerned about a housing bubble. A year and a half later, in March 2006, deep into the mortgage meltdown, he testified as Fed chairman that problems in the subprime market were “contained.”

In the twentieth century, capital markets democratized investing and stimulated novel solutions to major social problems: social security, sovereign funds, and personal savings accounts are all mechanisms intended to reduce household economic risk. They have deep roots in the history of finance.
Along with these important contributions to humankind, finance has also created problems: debt, market bubbles, devastating crises and crashes, exploitative corporations, imperialism, income inequality—to name only a few. The story of finance is the story of a technology: a way of doing things. Like other technologies, it developed through innovations that improved efficiency. It is not intrinsically good or bad.
TIME AND MONEY
The power of finance to effect such important transitions in world history is that it moves economic value forward and backward through time.

…

The fragmented political economy of Europe fostered the development of investment markets; the reinvention of the corporation; extra-governmental banking institutions; complex insurance contracts on lives, property, and trading ventures; and a sophisticated tradition of financial mathematics, reasoning, and analysis. These innovations, in turn, changed human behavior. I argue that they altered attitudes toward risk and chance, leading on the one hand to probabilistic thought and calculation and on the other hand to unbridled speculation that fueled the world’s first stock market bubbles. Europeans ultimately turned themselves and the rest of the world into investors.
The key stages in Europe’s development are first, the emergence of financial institutions; second, the development of securities markets; third, the emergence of companies; fourth, the sudden explosion of stock markets; fifth, the quantification of risk; and finally, the spillover of this system to the rest of the world.

…

Bob Shiller dreamed up (and patented) housing futures that could hedge against the decline in home equity. He proposed the creation of GDP-indexed products to hedge against unemployment. These products were met with mild interest in the boom years of the US economy, but, like other projectors before him, Bob Shiller may only have been ahead of his time. One of his ideas instantly caught the public’s imagination, however. He became famous for his study of stock market bubbles and his forecast of the bursting of the Internet craze.
A scholar with a gentle, inquiring demeanor, Bob Shiller has always had an interest in the psychology of the stock market. We came to know each other over years of talking about everything from econometrics to the puzzle of investor behavior. At one point in his stellar academic career, Bob took a chance and wrote a trade book, Irrational Exuberance, based on his conviction that the Tech Bubble would burst.

But at the turn of the century, 70% of companies listed in
the United States, including such highly rated companies as Microsoft,
had never paid a dividend. 6 Why then would anyone buy Microsoft
shares? Even if the company makes no distributions, it has earnings
and assets, and this gives value to the shares even if none of that value
is in practice passed to shareholders.
You may not find that argument entirely persuasive, nor do I; but
so long as enough people believe it, you and I can expect to be able to
sell our Microsoft shares to them. After the bursting of the stock market bubble in 2000, however, fewer people believed it than before. In
2003, Microsoft announced that it would pay its first dividend.
Valuing Securities
•••••••••••••••••••••••••••••••••••••
People who claim to predict share-price movements may be fundamental or technical analysts. Fundamental analysis looks at expec-
Culture and Prosperity
{171}
tations of future earnings and dividends. Technical analysis identifies trends in share prices that will help to predict future movements.

…

Business risks bring problems of asymmetric information and
moral hazard. Investors should always have the tale of the wallet
auction in their mind. Why are people who know more about this
venture and have more influence over its outcome than I do offering
a share of its potential profits to me? Why should I buy when they
Culture and Prosperity
{ 243}
want to sell? 19 Many people would be better off today if they had
asked that question during the stock market bubble.
The good reason for relinquishing a share of a potentially profitable investment is that the risk is too large for one individual or
institution. Antonio could handle the loss of one ship, but not of
three. Marine insurance would have enabled him to diversify the risk
of storm at sea, but the risks associated with his own business judgment remained. Christopher Columbus could not finance a venture
to find a shorter route to the spice islands of the Indies, but Queen
Isabella of Castile, substantially richer, could.

…

•••••••••••••••••••••••••••••••••••••
In The Methodology of Positive Economics) Friedman presents the
example of speculative trading to illustrate the thesis that rationality
is imposed by competitive market processes. He claims that market
speculation is necessarily stabilizing. Speculators make money only
if they buy cheap and sell dear; only speculators who make money
will stay in the market for long. So prices will fluctuate less in a market with active speculation than without. 21
Yet speculation in the stock market bubble was obviously destabilizing, driving prices to fantastic levels from which they subsequently collapsed. If all traders were perfectly rational (consistent,
Culture and Prosperity
{ 245}
self-interested, profit-maximizing, well-informed), there would be
no room for speculation, profitable or unprofitable. To give Friedman's argument a chance of being true, there needs to be a little bit
of irrationality-noise trading-but not too much.

Harvard economist Martin Feldstein noted that in 2004 alone, net mortgage borrowing not used for new home purchases, about $600 billion, represented nearly 7 percent of disposable personal income. In a related vein, over five years the housing sector was calculated to have provided nearly 40 percent of the increase in U.S. GDP and employment.
The further benefit was that rising home prices offset much of the nationwide loss of wealth—some $7 trillion—occasioned by the 2000- 2002 collapse of the stock market bubble, most notably the implosion of the tech-laden Nasdaq Index (see pp. 11-13, 62). In California, for example, the price of homes essentially tripled between 1995 and 2006, as you can see in Figure 4.4 on p. 114. Wealth-wise, this increase was gangbusters.
It was also a powerful tool of financial expansion, mortgage finance being one of the sector’s weightiest pillars. Virtually all the mega-firms were enthusiastic participants.

…

Obviously, this flood of private credit provided high-octane fuel for the expansion, leverage, and ambition of the financial sector, which seems to have passed manufacturing in the GDP data during the midnineties. Figure 2.5 measures the trot, canter, and gallop of the 1969- 2006 advance of financial debt, which left all other private debt expansion in the dust. The Flow of Funds Review & Analysis, published by the Virginia-based Financial Markets Center, offered one of the few explanatory backdrops as financial debt hit a crescendo in the year before the stock market bubble popped in 2000:FIGURE 2.5 The Triumph of Leverage
Source: Federal Reserve System, Flow of Funds Accounts of the United States.
These figures are the latest manifestation of a remarkable rise in financial sector indebtedness that dates to the late 1960s, when U.S. banks began borrowing Eurodollars in huge volumes from their offshore branches. . . . In each decade since 1969, the ratio of financial sector debt to GDP has nearly doubled.

…

Perhaps half of the money pumped into energy and communications debt vanished through bankruptcies and bear market clawings. The partially burst debt and credit bubbles of 2000-2002 had more than a little in common with the burst bubbles of 1969-70 and 1989-92. The floodtides of financial and nonfinancial corporate debt always leave a mess when the waters recede. Indeed, the high-tech and stock market bubble had popped while the Clinton administration was still in office.
In its initial months, with a recession already at hand, the administration of George W. Bush was dogged by his family’s and political associates’ closeness to Enron. Thereafter it was plagued well into 2002 by the Texas firm’s failure and apparent criminal culpability. Even so, the attack on Manhattan’s World Trade Center and the Pentagon on September 11 had pushed economic issues into a new, subordinated position.

A third set of economic factors has to do with the levels of debt (central, local, corporate, and bank) and asset bubbles in different sectors of the economy. China’s economy is already burdened by an estimated 282 percent of total debt as a percentage of gross domestic product (GDP). This is unsustainable in the eyes of many economists, despite China’s huge liquidity reserves. As for asset bubbles, 2014–2015 witnessed the bursting of urban property bubbles in several major cities, as well as the bursting of the stock market bubble on the Shanghai and Shenzhen exchanges. Excess manufacturing capacity and inventories are also problems. Another growing concern is the relative decline in foreign inbound investment, which is related to the increased costs and difficulties of operation for foreign multinationals in China. What other time bombs lurk waiting to burst in China’s opaque economy?
Socially, there are multiple variables to monitor.

…

Figure 2.3 China’s Alternative GDP Projections
Once again, we saw that the Visible Hand of the Chinese economy is the state. Every time the government intervenes to stem a temporary economic crisis it only exacerbates and deepens existing dependency on the state while further postponing much-needed reforms that would permit the economy to respond to real and transparent market signals.
The property market bubble has also peaked and declined precipitously in several major cities (due to oversupply and inflated prices for both residential and commercial units) while land sales are declining nationwide. The overheated market began to fall in mid-2012 and has continued a decline since, despite government intervention to prop it up. Over the subsequent two years, by mid-2014 the national property market had declined 25 percent.

…

The bursting of the bubble had long been anticipated by analysts who had tracked the blind building, overcapacity, and over-investment in the wake of the government’s 2008 stimulus package. Massive “ghost cities” stand eerily empty across the country.21 While it was a necessary self-correction, many ordinary Chinese who had bought homes for the first time are left with depleted equity; it will take a very long time to recover their initial investments. For China’s middle class and ordinary first-time investors, the twin “scissors effect” of the stock market and property market bubbles bursting has hit them hard. It is made worse by the fact that many of these eager citizens borrowed from secondary “shadow banking” entities to buy stock or a flat, and are now left with crippling debt.
Chinese officials have only themselves to blame as they openly encouraged the rise in share prices in 2014 and 2015, precisely because it suited their strategy of trying to reduce the economy’s dependence on credit: a buoyant stock market would give companies a way of funding themselves that did not put more debt on their balance sheets.

pages: 1,242words: 317,903

The Man Who Knew: The Life and Times of Alan Greenspan
by
Sebastian Mallaby

He freely conceded that Lindsey’s diagnosis was correct. “I recognize that there is a stock market bubble problem at this point,” he allowed; “I agree with Governor Lindsey that this is a problem that we should keep an eye on.” But he still planned to ignore Lindsey, despite the fact that he might be right. Even if the central bank’s mission was to deliver stable growth, and even if bubbles could destabilize growth just as surely as inflation, the Fed had decided to target inflation, mainly because the disinflationary forces in the world were making this the easy option. Following Lindsey’s advice, in contrast, would be hard. “We have very great difficulty in monetary policy when we confront stock market bubbles,” Greenspan declared to his colleagues. “To the extent that we are successful in keeping product price inflation down, history tells us that price-earnings ratios [and hence stock prices] under those conditions go through the roof.

…

But the truth, as revealed in Greenspan’s 1959 paper, is that he had been thinking about balance-sheet recessions for decades—in fact, he had been aware of them for longer than many of his critics had been breathing. The fact that he nonetheless allowed bubbles to inflate on his watch demands an explanation that goes deeper than his purported ignorance.
Greenspan’s attack on the 1920s Fed involved one further argument. The Fed’s mistake in the 1920s was not merely to rationalize the stock market bubble by embracing the talk of a new era of stability, akin to the “Great Moderation” that economists unwisely celebrated in the 1990s and 2000s. Rather, the Fed’s key error was to underestimate its own contribution to the stock bubble. The rise in the market had set off a rise in investment and consumer spending, which in turn had boosted profits and stoked animal spirits, triggering a further rise in the stock market.

…

Greenspan’s monetarism, and his dissent from the economics of the New Frontier, owed something to Milton Friedman.40 In A Program for Monetary Stability, published in 1960, Friedman had emphasized the destabilizing power of excess money creation, recommending that the central bank should target monetary growth that roughly matched output growth—in the absence of such a rule, discretionary policy would lead to inflation.41 In 1963, the year Greenspan sent out his letters, Friedman and his coauthor, Anna Schwartz, followed up with an enduring statement in favor of laissez-faire, A Monetary History of the United States. A large section of this masterwork was devoted to arguing that the Fed had made the Depression worse than it need have been, allowing the money supply to collapse in the 1930s and so suffocating businesses. The implication was that discretionary monetary policy had failed disastrously, not once but twice—the Fed had helped to bring on the Depression by fueling the stock market bubble of 1929, as Greenspan had argued in his 1959 article; and it had also rendered the aftermath unnecessarily painful. It is likely that Greenspan’s disapproving attitude toward central-banking orthodoxy was fortified by Friedman’s thesis. The year after the Monetary History appeared, he built on his client letters with an academic version of his critique, which appeared in the Journal of Finance.42
But by late 1963, Greenspan’s mind was turning to a more ambitious project.

This limitation of liability shall apply to any claim or cause whatsoever whether such claim or cause arises in contract, tort or otherwise.
Contents
Introduction
1 Fundamental Themes
2 What Happened?
3 Government Monetary Policy: The Fed as the Primary Cause
4 FDIC Insurance: The Background Cause
5 Government Housing Policy: The Proximate Cause
6 The Essential Role of Banks in a Complex Economy: The Liquidity Challenge
7 The Residential Real-Estate-Market Bubble and Financial-Market Stress
8 Failure of the Rating Agencies: The Subprime Mortgage Market and Its Impact on Capital Markets
9 Pick-a-Payment Mortgages: A Toxic Product of FDIC Insurance Coverage
10 How Freddie and Fannie Grew to Dominate the Home Mortgage Lending Business
11 Fair-Value Accounting and Wealth Destruction
12 Derivatives and Shadow Banking: A Misunderstanding
13 The Myth that “Deregulation” Caused the Financial Crisis
14 How the SEC Made Matters Worse
15 Market Corrections Are Necessary, but Panics Are Destructive and Avoidable
16 TARP (Troubled Asset Relief Program)
17 What We Could Have—and Should Have—Done
18 The Cure for the Banking Industry: Systematically Move Toward Pure Capitalism
19 Some Political Cures: Government Policy
20 Our Short-Term Path and How to End Unemployment
21 The Deepest Cause Is Philosophical
22 The Cure Is Also Philosophical
23 How the United States Could Go Broke
24 The Need for Principled Action
25 Conclusion
Notes
Index
Acknowledgments
Introduction
THE PURPOSE OF THIS BOOK IS TO PROVIDE AN INTEGRATED INSID-er’s perspective on the recent financial crisis, the related Great Recession, and why a meaningful economic recovery has not occurred.

…

Many defenders of the Federal Reserve drop the context; that is, they see the Fed’s ability to provide liquidity as reducing risk. They ignore the fact that the very existence of the Fed creates extremely powerful incentives (human nature) for bank managements to increase risk in good times. Instead of being countercyclical, as its proponents argue, the Fed is pro-cyclical because of its effect on human behavior through the financial and psychological incentives that it creates.
7
The Residential Real-Estate-Market Bubble and Financial-Market Stress
AS WE HAVE DISCUSSED, THE “BURSTING” OF THE BUBBLE (MISIN-Vestment) in the residential real estate markets led to the deterioration of the capital markets and to the Great Recession. In reality, it was the actions that led to the misinvestment (bubble) in the first place that were destructive. The bursting of the bubble was both inevitable and healthy for the economy in the long term.

…

The interesting aspect of this situation is that the negative consequences for the bond market could have been avoided and the risk of retail bank runs controlled. The FDIC could have simply absorbed the extra losses paid to the uninsured depositors. The FDIC’s mission is to protect the safety and soundness of the banking system. If covering uninsured depositors is necessary, it can do so, but it should let the losses fall on the insurance fund, not on innocent bondholders. Violating the rule of law has consequences.
The bursting of the real estate–market bubble turned into an international financial crisis for several reasons. First, foreign financial institutions had invested heavily in the U.S. housing market. They suffered capital losses and the resulting reductions in liquidity (lending capacity), as previously described for U.S. institutions, and these reductions were then transmitted to their home economies. Second, there were housing bubbles created by the central banks in a number of other countries (such as Ireland and Spain), and these bubbles also burst.

That said, looking at data since the late 1980s, it follows that
value stocks outperformed as the economy went into a recession and there was
uncertainty regarding the tax code. Growth stocks next outperformed during
the gridlock period, when moves to higher taxes and regulation were arrested
by a divided government. Add to that low and steady inflation and there was
little uncertainty during the mid- and late 1990s. When the corporate scandals
broke, and the stock market bubble popped, uncertainty crept back in and
value stocks reigned once again.
The Location Cycles
Before I get into location cycles, I need to make some assumptions about
exchange rates. In the long run (by this, I mean the economy will approach its
equilibrium in the long run), purchasing power parity (PPP) will be restored.
PPP is the point at which exchange rates have adjusted based on the purchasing power of currencies.7 If the world we live in were frictionless, all adjustments would be instantaneous.

…

After that, the tax policies of Presidents Bush and Clinton
brought about a cycle in which capital gains’ advantage over dividends steadily
increased. Not surprisingly, returns in the 1990s were generated mostly in the
form of capital gains as the corporate structure changed to take advantage of
the tax laws. Ultimately, corporate behavior also adjusted, with some companies
going over the line. All this of course changed when the stock market bubble
burst in the late 1990s, subsequently reducing the dividend tax rate. At the
present moment, the advantage of capital gains over dividends has been completely eliminated.
Now let’s focus again on cycles, beginning with high-yield Treasury bonds (Tbonds). The first round of Reagan tax-rate cuts (The Economic Recovery Tax
Act of 1981) represented a major inflection point in the relative rankings of the
costs of the return-delivery vehicles.

…

Clearly, price declines induced by supply shifts are quite bullish for the world
economy. On the other hand, price declines induced by demand shifts are
quite bearish (see Figure 11.3d). A lack of demand induces a doubly negative
effect on profits. Not only do producers collect less money per unit sold, they
also sell fewer units. The quintessential example of this is Japan during its
deflation years—a stock market bubble that burst in the early 1990s reduced
the net worth of individuals and corporations alike. In turn, the credit worthiness of companies was reduced, forcing banks to curtail their loans. The
decline in asset prices also reduced the net capital and capital adequacy of the
banks, forcing them to further curtail their loan operations. These conditions
created what some called a liquidity trap. As the Japan central bank printed
money to stimulate the economy, the commercial banks did not lend the extra
money.

The technical phrase for this type of process is negative feedback, and it is found in most stable dynamic systems, such as thermostat-controlled heating systems and the body’s hormonal system. When an initial disturbance occurs, price changes set in force offsetting movements, which restore equilibrium. (The opposite of negative feedback is positive feedback, which amplifies initial disturbances. Positive feedback helps to cause nuclear explosions, rapid population growth, and stock market bubbles.) It should be noted that none of these adjustments is imposed from above: in the language of systems analysis, they are all “emergent” properties, which result from a multiplicity of individual interactions. Each businessman “intends only his own gain,” Smith wrote, “and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention . . .

…

In the world of Arrow-Debreu, firms are merely shells that react to market prices by transforming inputs into outputs. There is no room for innovation. There are no monopolists, such as Microsoft, and no oligopolists, such as Exxon Mobil and Chevron, Citigroup and Goldman Sachs. Financial markets exist, but only in a very abstract form. People are assumed to plan ahead for every possible state of the world and make contingency plans for each of them. There is no place for stock market bubbles, banking crises, or lending crunches. The typical ups and downs of a modern credit-driven economy are nowhere to be seen.
When I interviewed Lucas in 1996, he was engagingly modest about his achievements, perhaps because he could afford to be. (The preceding year, he had visited Stockholm to pick up his Nobel.) “I write down a bunch of equations, and I say this equation has to do with people’s preferences and this equation is a description of the technology,” he said.

…

“The assumption of ‘rational expectations’ as a modeling device is now entirely orthodox,” Michael Woodford, one of the leading New Keynesians, wrote in 1999.
The third-generation rational expectations models can be useful for exploring the old question of how central banks should set interest rates to achieve a low and stable rate of inflation, but they have virtually nothing to say about what policymakers should do to maintain financial stability. As in the original Lucas models, there is no role in them for stock market bubbles, credit crunches, or a drying up of liquidity. Indeed, recognizable financial markets don’t really exist. The illusions of harmony, stability, and predictability are maintained, and Hayek’s information processing machine does its job perfectly: at all times, prices reflect economic fundamentals and send the right signals to economic decision-makers.
Even the creators of these models concede that they don’t provide any guidance for policymakers in times of financial turbulence.

What made the challenge far more difficult is that the sector of the domestic economy best equipped to spend more than its income or, more precisely, invest more than its savings, is the corporate sector. It did just that at the peak of the stock-market bubble in the late 1990s: indeed its financial deficit, thus defined, reached 4 per cent of GDP. But from 2000 to the crisis of 2008, the business sector was in rough balance, despite the easy monetary policy (see Figure 33).33 This is largely because gross business investment peaked at 13.6 per cent of GDP in the second quarter of 2000, as the stock-market bubble burst. It then fell to 10.1 per cent of GDP in the second quarter of 2003, before rising modestly to 11.8 per cent in the second quarter of 2007, as the economy recovered, just before the global financial crisis. It then collapsed, in response to the crisis and subsequent deep recession, reaching a nadir of 7.5 per cent of GDP in the third quarter of 2009.

…

That is why Japan has periodically felt obliged to keep the yen down by accumulating foreign-currency reserves.27 The aggressive monetary policies of Abenomics, introduced under Prime Minister Shinzo Abe, may also be an attempt to restore lost growth by improving external competitiveness: between November 2012 (that is, just before he became prime minister for the second time) and July 2013, the JP Morgan broad trade-weighted real exchange rate of the yen fell by 17 per cent.
We can only understand the challenges for US policymakers after 1997, particularly for the Federal Reserve, in the light of what was happening elsewhere. Their job, mandated in law, was (and is) to stabilize inflation and keep unemployment low in the US. We may define this combination as internal balance. Between 1997 and 2000, the stock-market bubble did a good job of sustaining demand without any need for heroic monetary policy (see Figure 29). But the bubble then burst. The Fed found itself confronting a much weaker economy. It slashed interest rates. Then came another shock – the terrorist attack of 11 September 2001. The recovery was weak. Worry grew that the US might fall into Japan’s deflationary malaise. Mr Bernanke defined this concern, too, in an influential speech delivered in November 2002, entitled, tellingly, ‘Deflation: Making Sure “It” Doesn’t Happen Here’.28
The Federal Reserve’s intervention rate was reduced to 1 per cent.

…

But there was no chance that central banks would have got away with such a policy in the absence of general inflationary pressure. It would have violated their explicit mandates. Anybody who argues for such a policy is, in essence, arguing for a different monetary regime.
The final question is how far it is possible to live with a financial system capable of imploding in response to what was no more than a modest policy mistake, given the obvious reasons for loose monetary policy after the implosion of the stock-market bubble in 2000 and the terrorist attacks on the US of 11 September 2001. That is perhaps the biggest question of all, to which I will turn in Part III.
For all these reasons, the argument that what was needed was a tighter monetary policy does not get us far. The question is how much tighter and with what consequences. In essence, critics of monetary policy in the early 2000s and again today are suggesting that fine-tuning the economy via monetary policy risks dangerous unintended consequence.51 This is correct.

I had read in the newspaper that morning that Colombian government bonds were paying only 100 basis points above U.S. Treasuries, which struck me as nutty. Sure, the Colombians were doing much better at managing their economy, and I claimed no special expertise about the country. But a mere 100 basis points over Treasuries, which implied a 1 percent expected loss rate per annum, seemed wildly optimistic. So when I came to the part of my speech about the bond-market bubble and put a picture of Wile E. Coyote on the screen, I had Colombian debt on my mind. When I asked who among the assembled brokers thought that 100 basis points was a reasonable spread over U.S. Treasuries, not a single hand went up. Then I broke the news: The market does, because that’s what Colombian bonds sell for today.
By early 2006, I had grown tired of listening to myself speak about the bond bubble to deaf ears.

…

If a Treasury bond would pay you only 4.5 percent interest, but a mortgage-backed security with (allegedly) negligible default risk would pay you 6 percent interest instead, why not sell the Treasury bond and buy the MBS, picking up an extra 150 basis points in the process? Seems like a no-brainer, right? And if default risk really is negligible, it is. But, of course, the risk wasn’t negligible. Investors should never have extrapolated the amazingly favorable default experience of 2004–2006 into the indefinite future. But they did. It was the kind of thinking that led to the bond-market bubble.
As investors shifted out of Treasuries into riskier fixed-income securities—whether Columbian government bonds or MBS backed by subprime mortgages—those riskier securities were bid up in price, and hence down in yield. You had to pay more to buy the same stream of interest payments. So what was once, say, a 150-basis-point reward for bearing more risk became a 100-basis-point reward, or maybe just a 50-basis-point reward.

…

I’ll explain how that worked shortly, but first let’s pause for a moment to think about remedies—or at least palliatives.
Can we prevent asset-price bubbles in the future? Here, unfortunately, the answer is mostly no. Speculative markets have succumbed to occasional bubbles for as long as there have been speculative markets. Indeed, one of the first common stocks ever issued, in the South Sea Company in England, was hyped into the first stock-market bubble—the famed South Sea Bubble of 1720—which devastated, among others, a pretty smart fellow named Isaac Newton. And the Dutch had managed to grow a gigantic bubble in—of all things—tulip bulbs almost a century earlier.
No, while we may be lucky enough to nip a few bubbles in the bud, we will never stamp them out. The herding behavior that produces them may well be programmed into our DNA. Our best hope is to minimize the consequences when bubbles go splat—as they inevitably will.

The Federal Reserve chairman, William McChesney Martin, however, was more determined than the administration economists to stop the rise in inflation, and the Fed sharply raised the interest rate it uses as a target to set monetary policy (the federal funds rate). It is the interest rate on funds banks lend to each other to meet requirements for the reserves against bank loans required by the Fed. The Fed raised it from roughly 6 percent to 9 percent that year. Once the Fed started raising rates, the previously soaring stock market cracked almost immediately. As a consequence of the higher rates and the burst market bubble, GDP contracted toward the end of 1969 after nearly ten years of expansion, and the rate of unemployment began to rise. The stock market continued to plummet in the first half of 1970, and the economy officially slid into recession as the unemployment rate rose above 6 percent.
Until this point, economists believed the New Economics had largely solved the problem of serious economic recession.

…

Raising interest rates to subdue the stock market might diminish the market enthusiasm, but it might also weaken the economy. In a speech in December 1996, Greenspan suggested that the stock market might have reached a stage of “irrational exuberance.” It was a Sunday, but markets then open in Australia and New Zealand immediately fell, leading to a cascade of falling prices around the world. Would the Greenspan Fed now raise interest rates to burst the stock market bubble? The Dow Jones Industrials fell sharply the next day, and Greenspan was chastened by the market response. The Fed did not raise rates and calm quickly returned.
Despite rapid economic growth at an annual rate of 4 percent or more, inflation fell below 3 percent in 1997 and below 2 percent in 1998. Greenspan was convinced that computer technologies were at last taking hold across American business, meaning that the nation could get rising output per worker—more productivity—and pay substantial raises without raising prices.

…

Greenspan was at last also apparently worried about the overpriced stock market.
In June, the Fed raised the federal funds rates by .25 percent, the first increase since early 1997, followed by five more increases, the last a major hike of .5 percent. In total the federal funds target was raised from 4.75 percent in early 1999 to 6.5 percent in May 2000.
The rate hikes took their toll. The stock market bubble burst in midyear. By the end of 2000, the Nasdaq index had fallen from a high of 5,000 to 3,500 on its way down to nearly 1,000 in 2003. By early 2001, the Dow Jones Industrials lost 1,000 points from its high above 11,000, revived slightly, and then headed to below 8,000 two years later. The long period of growth, overspeculation, and overinvestment in high technology and telecommunications was coming to an end, and lower stock prices and rising interest rates brought on a serious recession as George W.

Arbitrage is only riskless in the extreme case of perfect substitutability and frictionless markets. Most real-world “arbitrage” opportunities deserve quotation marks because they are only “good deals” that can move against the arbitrageur. With micro-inefficiencies where good substitutes (highly correlated assets) exist, arbitrageurs can put on relative value trades so that some of the risk in arbitrage is hedged. With macro-inefficiencies (say, a market bubble) without good asset substitutes, such hedging is not possible, so the arbitraging of market-level mispricing is risky and unattractive.
Arbitrageurs face both the fundamental risk of adverse news and the “noise trader risk” of the possibility that sentiment will make mispricing worse. If arbitrageurs have longer horizons than noise traders, they can be more aggressive and can “ride out” temporary mispricings.

…

Bubbles and many other observed anomalies can be explained by psychological stories, as well as by alternative, rational, risk-based stories.
6.3.1 Speculative bubbles and other macro-inefficiencies
Robert Shiller’s book Irrational Exuberance, which summarizes his work of over 20 years, was published, with some luck, in March 2000 just at the peak of the equity bubble. Shiller’s timing was only slightly off with the second edition which emphasized housing market overvaluation; it came out in 2005, two years before the U.S. real estate bubble burst. Since Shiller’s thinking on this topic is as insightful and influential as anyone’s, I describe his theory on bubbles before discussing some other analyses.
Shiller argues that equity market bubbles have four elements:1. Precipitating factors. What gets the bubble started? In the late 1990s, the Internet boom was the most important factor, but other important factors included improving macro-fundamentals (lower inflation and real yields) and the tendency of middle-aged baby-boomers, with high savings rates, to allocate much of their buying to the stock market.
2. Amplification mechanisms.

…

Other research also confirms that fast credit growth and financial deregulation /innovation are common characteristics of major booms that end in tears.
Bubbles have a long, infamous history since the Dutch tulip mania (1637) and the South Sea and Mississippi company bubbles (both about 1720). Wall Street in 1929, Japan in 1989, and global technology stocks in 1999 are the most famous equity market bubbles of the past century. Of course, there are alternative explanations for these high equity prices but the explanations involving purely rational stories, such as time-varying risk premia, are unsatisfactory. Credit and real estate bubbles may be even more detrimental to the real economy than equity bubbles, because the former reside closer to the heart of the financial system and may be harder to detect [4].

The close linkages between these markets and the American state were thus crucial both to the making of the US housing bubble and to its profound global impact when it burst, as mortgage-backed securities became difficult to value and to sell, thus freezing the world’s financial markets. But crucially important in explaining why the financial crisis turned into such a severe economic crisis was that the collapse of housing prices also undermined workers’ main source of wealth, leading to a dramatic fall in US consumer spending. The bursting of the housing bubble thus had much greater effects than had the earlier bursting of the stock-market bubble at the turn of the century, and much greater implications for global capitalism in terms of the role the US played as “consumer of last resort.”
In true imperial fashion, the US fully shared its problems with the rest of the world. Given the role of US financial assets and consumer spending in global capitalism, illusions that other regions might be able avoid the crisis were quickly dispelled.

…

After 1926 the Federal Reserve kept US interest rates low, in order to support sterling following Britain’s return to the gold standard; yet the main effect of low interest rates was to shift funds from bonds to further speculation in already overheated US stock and real-estate markets. Then, when in 1928 the Fed undertook a relatively modest interest-rate increase to dampen this down, it triggered a massive diversion of funds away from foreign loans, with immediate deflationary effects abroad. Finally the sudden bursting of the stock and real-estate market bubbles in October 1929 more or less completely cut off the flow of US credit that had kept the rickety international financial system going through the 1920s.34
On the eve of the 1929 New York stock market crash, the American economy accounted for no less than 42 percent of global industrial production—far more than Britain’s share even at its peak in 1870.35 That said, the development of the US domestic economy was itself highly uneven.

…

The Plaza Accord only finally ended what Japan’s own finance minister admitted was the American state’s long-standing toleration of an exchange rate that had amounted to a “subsidy to Japan’s exports to the United States and an import surcharge on US exports to Japan.”71
Japanese banks briefly came to dominate the standard rankings of the world’s largest financial institutions as they provided easy credit for Japan’s historically unprecedented purchase of assets abroad, and became conduits for a real estate and stock-market bubble inside Japan. But their vastly expanded assets concealed highly questionable lending and corporate reporting practices, as well as a technological backwardness that belied their size and prominence (in the late 1980s check-clearing in Tokyo was still done by hand rather than computer, and there were as yet no twenty-four-hour ATMs).72 Even before Plaza, Japanese banks were already implicated in the collapse of Continental Illinois, and after Plaza they were even more implicated in the US stock market crash of 1987.73 At the same time, the Ministry of Finance and the Bank of Japan not only had increasingly less effective control over what was happening in their domestic financial system, but also demonstrated little interest in seeing the yen displace the dollar as the world’s reserve currency—much less in assuming the responsibilities of global financial leadership.

The chart The Japanese Stock-Market Bubble: Japanese Stock Prices Relative to Book Values, 1980–2000 shows quite dramatically that the rise in stock prices during the mid-and late 1980s represented a change in valuation relationships. The fall in stock prices from 1990 on simply reflected a return to the price-to-book-value relationships that were typical in the early 1980s.
The air also rushed out of the real estate balloon during the early 1990s. Various measures of land prices and property values indicate a decline roughly as severe as that of the stock market. The bursting of the bubble destroyed the myth that Japan was different and that its asset prices would always rise. The financial laws of gravity know no geographic boundaries.
THE JAPANESE STOCK-MARKET BUBBLE JAPANESE STOCK PRICES RELATIVE TO BOOK VALUES, 1980–2000
Source: Morgan Stanley Research and author’s estimates.

…

Of course, my friend had bought in just at the height of the bubble, and he lost his entire investment when the firm declared bankruptcy. The ability to avoid such horrendous mistakes is probably the most important factor in preserving one’s capital and allowing it to grow. The lesson is so obvious and yet so easy to ignore.
THE U.S. HOUSING BUBBLE AND CRASH OF THE EARLY 2000s
Although the Internet bubble may have been the biggest stock-market bubble in the United States, the bubble in single-family home prices that inflated during the early years of the new millennium was undoubtedly the biggest U.S. real estate bubble of all time. Moreover, the boom and later collapse in house prices had far greater significance for the average American than any gyrations in the stock market. The single-family home represents the largest asset in the portfolios of most ordinary investors, so falling home prices have an immediate impact on family wealth and sense of well-being.

…

We know now that real estate prices in the United States were wildly overpriced in 2006 and early 2007. We know now that there would have been enormous opportunities for profit by selling short Internet stocks in early 2000 and selling overpriced homes and commercial real estate in 2007. But neither of those mispricings was nearly as obvious before the crash occurred in both markets.
Critics would argue that the technology-Internet stock-market bubble was easy to identify as it was inflating. Robert Shiller published his book Irrational Exuberance in early 2000, just at the peak of the market. True, but the same models that identified a bubble in early 2000 also identified a vastly “overpriced” stock market in 1992, when low dividend yields and high price-earnings multiples suggested that long-run equity returns would be close to zero in the United States.

On 14 December, Pole & Co. stopped payment, which put forty of its correspondent county banks out of business.15 Pole & Co. had been put under pressure by an old-fashioned bank run, when depositors simply withdrew their money from the bank.
The bank failures were only the last development of what had been a tumultuous year. The South American mining stocks also collapsed in dramatic fashion. One man caught up in the excitement of the stock market bubble was the young Benjamin Disraeli, a twenty-year-old Jewish adventurer, determined to make a name for himself in literature. The young Disraeli was a mere solicitor’s clerk who eagerly and cynically speculated in South American shares. After the South American republics, which were fighting wars of independence from Spain, had been recognized as sovereign states just after Christmas 1824, there was a huge boom in the shares.

…

In March 1825 there appeared Disraeli’s first published work, an anonymous pamphlet, nearly a hundred pages in length, entitled An Enquiry into the Plans, Progress, and Policy of the American Mining Companies. Disraeli wrote a further two pamphlets, the last of which was entitled The Present State of Mexico. These works were largely fictional accounts of the immense resources which were said to underpin the mining securities. Disraeli fatally borrowed money ‘on margin’ to acquire the stocks, and was £7,000 in debt by June 1825 when the stock-market bubble burst. These debts would hang over his finances for decades.16
Despite the outward show of respectability, it must be remembered that Victorian finance was often a highly speculative affair. The era of the gold standard was also an era when prominent financiers could go bankrupt and, metaphorically at least, lose their shirts. The British government may have ‘virtually balanced’ its budget in every year from 1815 to 1914, but at least four out of eight Governors of the Bank of England between 1833 and 1847 (Governors held the post for two years before handing over to the Deputy Governor) suffered the humiliation of personal bankruptcy.17 One of these six Governors was the unfortunate William Robinson, a corn dealer, who became bankrupt during his governorship.

…

Blinder, a Princeton professor who had served as Vice Chairman of the Federal Reserve, ‘for the most part [they] meant what Greenspan wanted to do’.4 It became fashionable to blame Greenspan after the financial crisis of 2008 had damaged the US economy. Indeed, in February 2009, Time magazine listed the former central banker at number three in their list of ‘25 People to Blame for the Financial Crisis’.5 Yet, even before the memorable events of 2008, some critics had already begun to blame him for overheating the economy. In its August 2005 article, the New York Times accused him of presiding over ‘a stock market bubble that burst’. His attempts to mitigate the collapse of stock prices had led, in turn, to the ‘housing boom’ and to the ‘potential bust’. The Times also pointed to the accumulation of ‘heavy foreign debt’. This had a simple cause: the Federal Reserve ‘drove interest rates so low that Americans borrowed more and saved less’.6
Greenspan’s belief in the efficacy of free markets had led him to a relaxed view of regulation, and to a scepticism about rigid control of economic variables.

The 3.4 percent holding period increment, realized by PCA bondholders over the three and one-half years, represents scant compensation for accepting a high degree of credit risk. U.S. Treasuries produced risk-adjusted returns significantly higher than those realized by holders of the PCA9.625s.
Holders of PCA stock faced a tough set of circumstances. In contrast to the strong market enjoyed by bondholders, equity owners faced a dismal market environment. From the date of PCA’s IPO, which took place near the peak of one of the greatest stock market bubbles ever, to the bond-tender offer date, the S&P 500 declined a cumulative 24.3 percent. Bucking a decidedly adverse market trend, PCA’s equity rose from the initial offering price of $12.00 in January 2000 to $18.05 on July 21, 2003, representing a holding-period gain of 50.4 percent. Even in the worst of worlds for equity holders and the best of worlds for bondholders, the equity owners of PCA eked out a victory.

…

Not until more than four years after the crash did the equity share of mutual-fund assets rise to the pre-crash level. Not until nearly five years later did money-market assets decline to the pre-crash level. Amid one of the greatest bull markets of all time, mutual-fund investors held cash-heavy, equity-light portfolios.
INVESTOR REACTION TO THE INTERNET BUBBLE
Investors receive similarly poor marks for their asset allocation of mutual funds during the inflation and deflation of the 1990s stock market bubble. Throughout the bull market, mutual-fund investors consistently increased stock holdings at the expense of bond and money-market allocations. Consider the period from 1993 to 2000. Investors registered equity-allocation readings in the 30 percent range in 1993 and 1994, in the 40 percent range from 1995 through 1997, in the 50 percent range in 1998 and 1999, and in excess of 60 percent at the market peak in 2000.

…

When an asset class performs relatively well, rebalancing requires compensating sales. Under normal market conditions, rebalancers occupy a mildly contrarian space, seen as slightly out of step with conventional wisdom.
In times of severe market stress, rebalancing takes on a decidedly dramatic cast. Market collapses require substantial purchases in an environment pervaded by bearish sentiment. Market bubbles require substantial sales in an environment suffused with bullish enthusiasm. Under extraordinary market conditions, rebalancers must demonstrate unusual determination and fortitude.
In spite of the central importance of rebalancing to effective portfolio management, investors appear largely indifferent to the process. Evidence indicates that, at best, investors allow portfolios to drift with the ebb and flow of the market, causing strong relative performance to increase allocations and weak relative performance to diminish holdings.

Greenspan cemented his status as a guru with unique foresight in the mid-1990s with an intellectually courageous call that the Internet-based New Economy was so fundamentally changing the U.S. economy that the Fed could permit the economy to grow faster than most inflation-fearing economists thought prudent. The result was lower unemployment without higher inflation — and a technology stock market bubble for which Greenspan got substantial blame. But even after that bubble burst, and a recession ensued, the Greenspan Fed managed to get the economy going again by aggressively cutting interest rates — and the United States avoided the misery that followed the bursting of a real estate and stock market bubble in Japan.
Bush was right. Greenspan was a rock star — at least at that moment. He had steered the U.S. economy around the Asian financial crisis in 1998, two wars with Iraq, and the September 11 attacks. To economists, bond traders, and businessmen, he was a hero.

…

Indeed, this was an assumption on which an entire financial house of cards rested. And it was wrong.
Greenspan’s unwillingness to attack the housing bubble wasn’t only about misreading signs. It also reflected a philosophical view about central banks targeting rising asset prices. In an approach Bernanke backed at the time, Greenspan argued that central banks shouldn’t increase interest rates to attack possible market bubbles because they can’t always distinguish a transitory bubble from a sustainable rise in prices. Simply put, the Fed was as likely to aim at a false bubble and kill economic growth as it was to prevent one from inflating.
Greenspan also argued that the central bankers’ other tool — talking investors out of their euphoria — was extremely limited. His famous “irrational exuberance” warning came in December 1996 when the Dow Jones Industrial Average was at 6,500.

But in the wake of a number of financial crises, from the dot-com implosion of 2000 to the subprime mortgage crisis of 2008 and the financial meltdown that followed, we were rudely awakened to the reality that psychology and irrational behavior play a much larger role in the economy’s functioning than rational economists (and the rest of us) had been willing to admit.
It all started from questionable mortgage practices, augmented by collateralized debt obligations (CDOs are securities based mostly on mortgage payments). In turn, the CDO crisis accelerated the deflation of the housing market bubble, creating a reinforcing cycle of decreasing valuations. It also brought to light some questionable practices of various players in the financial services industry.
In March 2008, JP Morgan Chase acquired Bear Stearns at two dollars per share, the low valuation resulting from the fact that Bear Stearns was under investigation for CDO-related fraud. On July 17, major banks and financial institutions that had bet heavily on CDOs and other mortgage-backed securities posted a loss of almost $500 billion.

…

Who knows? If such calculators had existed during the last 10 years, maybe much of the mortgage fiasco would have been avoided.
Despite my belief in the desire of borrowers to make the right decisions (and to avoid the disastrous outcomes of making wrong decisions), I must admit that even if some of the banks had created better mortgage calculators, it is possible that in the delirium of the housing market bubble, zealous bankers and real estate brokers could still have pushed people to borrow more and more.
This is where regulators could have stepped in. After all, regulation is a very useful tool to help us fight our own worst tendencies. In the 1970s, regulators placed strict limits on mortgages. They dictated the share of income that could be used to pay a mortgage, the amount of down payment required, and the proof that borrowers had to show to document their income.

But thanks to you, we won’t do it again.
—Fed Governor Ben Bernanke1
What a pity that Bernanke did not read Ludwig von Mises instead of Milton Friedman in graduate school! If he had, he would have known that credit creates the boom and that all booms bust. Instead, he was taught that the Great Depression occurred because the Fed made two mistakes:
1. It increased interest rates in late 1928 to slow down the stock market bubble.
2. It did not print money and bail out all the banks when the credit the banks had extended could not be repaid.
By putting into practice those mistaken lessons drawn from the Great Depression, Bernanke and his colleagues at the Federal Reserve have brought upon the United States and the world the New Depression. Guided by a flawed interpretation of historic events, the Fed, beginning with Greenspan and continuing under Bernanke, has done absolutely everything in its power to perpetuate the credit boom in the United States.

…

In other words, there has been no adjustment to the global imbalances that played a leading role in creating this economic disaster. The elimination of those imbalances is inevitable, and it still lies ahead.
Looking ahead, the rest of the world won’t buy more from the United States. It will buy less. When the United States buys less from other countries, other countries have fewer dollars and so will buy less from the United States. That was one of the lessons from 2001 when the stock market bubble popped and from 2008 when the housing bubble popped. External factors will exacerbate the depression in the United States during the years ahead, not ameliorate it.
Vision and Leadership Are Still Lacking
The adoption of fiat money permitted the abuse of Keynesian stimulus on a scale that would have horrified John Maynard Keynes, and it opened up possibilities for credit expansion that earlier generations of economists would not have dreamt possible.

Property prices rose at a similar rate to the United States
and ever since 2002–03 the Australian household savings
rate has been negative.
Back in June 2005, the Economist published these prophetic words: “Never before have real house prices risen so
fast, for so long, in so many countries. Property markets have
been frothing from America, Britain and Australia to France,
Spain and China. Rising property prices helped to prop up
the world economy after the stock-market bubble burst in
2000. What if the housing boom now turns to bust?” These
frothy property prices were fuelled by a combination of low
interest rates, loosening lending standards, growing consumer
appetite for debt and extensive use of securitisation [pooling
and repackaging], which effectively allowed home buyers to
access capital from all around the world.
87
The Global Financial Crisis
It has been estimated that from 2004 to 2006, more than
20% of new US mortgages were taken out by “subprime” borrowers with poor credit histories and limited capacity to service their loans.

Therefore, whereas Apple seemed adequately priced based on current earnings (a forward prospective P/E of
16 at the time of the interview), it was screamingly cheap based on Taylor’s estimate of earnings three years forward (a P/E under 5).
Investors often make the mistake of equating manager performance in a given year with manager skill. In some instances, more skilled
managers will underperform because they refuse to participate in market bubbles. In fact, during market bubbles, the best performers are often the
most imprudent rather than the most skilled managers. Taylor underperformed in 1999 because he thought it was ridiculous to buy tech stocks at
their inflated price levels. This same investment decision, however, was one of the key reasons why he strongly outperformed in subsequent years
when these stocks experienced an extended slide.
1The fund documents required Taylor to give investors a 12-month notice before terminating the fund.
2MSCI Emerging Europe index 1995–2002 and MSCI Global Emerging Markets index 2003–2011.
3“The city” is a small historic section in central London that is the heart of the financial district.
4It is an accounting tautology that the sum of the current account balance and the capital account balance is equal to the change in net
reserves.

…

The popular perception of the successful global macro manager is a trader who has an ability to forecast major trends in world markets (FX,
interest rates, equities, commodities) through skillful analysis and insight. O’Shea emphasizes that his edge is not forecasting what will happen, but
rather recognizing what has happened. O’Shea believes that it is very difficult to pick a major turning point, such as where a market bubble will top,
and that trying to do so is a losing strategy. Instead, he waits until events occur that confirm a trading hypothesis. For example, he thought that
excessive risk-taking during 2005 to 2007 had inflated various markets beyond reasonable levels and left the financial markets vulnerable to a
major selloff. Nevertheless, insofar as he sees his role as trading in response to the prevailing market facts, rather than forecasting turning points,
he actually had bullish positions on during this time.

…

Since his bearish hypothesis was inconsistent with the market price action, he
formulated an entirely different hypothesis that seemed to fit what was happening—that is, the markets were seeing the beginning of an Asia-led
economic recovery. Staying with his original market expectation would have been disastrous, as both equity and commodity markets embarked on
a multiyear rally. The flexibility to recognize that his premise was mistaken and to act on that awareness allowed O’Shea to experience a profitable
year, even though his original market outlook was completely wrong.
O’Shea believes that the best way to trade a market bubble is to participate on the long side to profit from the excessive euphoria, not to try to
pick a top, which is nearly impossible and an approach vulnerable to large losses if one is early. The bubble cycle is easier to trade from the long
side because the uptrend in a bubble is often relatively smooth, while the downtrend after the bubble bursts tends to be highly erratic. There are two
components necessary to successfully trade the long side of a bubble.

, resonated as loudly with investors in 2010 as it did when he first published his classic Wall Street book of the same title in 1940.1
The particular thrashing that engendered the sweeping market reforms of 2005 took place in 1969 and 1970 when a stock market bubble burst and the consequent bear market slashed into Wall Street’s brokerage profits, exposing the undercapitalized positions of more than 100 brokerage firms.2 This massive collapse of so-called “white shoe” firms marked the first significant catastrophe for Wall Street since the Great Depression, and it was a wakeup call for Congress that the New York Stock Exchange (NYSE) and its regulator, the Securities and Exchange Commission (SEC), were not on the ball.3
The capital crisis was part of a one-two punch. The first punch was an embarrassing paperwork fiasco in 1968. Brokerage houses were overwhelmed by an unexpected influx of new customers at the zenith of a stock market bubble. The newcomers, expecting to get rich quickly, invested heavily in smaller, highly speculative stocks.

But often a bubble is generated by a belief that turns out to be mistaken that fundamentals are changing—that a market, or maybe the entire economy, is entering a new era of growth, for example because of technological advances. Indeed that is probably the main cause of bubbles.
A stock market bubble developed in the 1920s, powered by plausible optimism (the years 1924 to 1929 were ones of unprecedented economic growth) and enabled by the willingness of banks to lend on very generous terms to people who wanted to play the stock market. You had to put up only 10 percent of the purchase price of the stock; the bank would lend the rest. That was risky lending, since stock prices could and did decline by more than 10 percent, and explains why the bursting of the stock market bubble in 1929 precipitated widespread bank insolvencies. New profit opportunities and low interest rates had led to overindebtedness, an investment bubble, a freezing of credit when the bubble burst because the sudden and steep fall in asset prices caused a cascade of defaults, a rapid decline in consumption because people could not borrow, and finally deflation.

The very centrality of installment credit to the New Era is what made it so susceptible to blame for that era’s demise. Historians today do not believe that overextension of installment credit caused the Great Depression—they don’t even discuss it as a viable possibility—but to those who lived through the Great Depression, installment credit’s role was more certain.36 Installment credit, in this view, was akin to the speculative credit that had fed the stock market bubble. The “artifice” of installment credit attracted much blame. In 1932, for example, a Johns Hopkins economics professor identified credit among the three main causes of the Depression: “perversion of the stock exchanges,” “degradation of banking,” and “reckless installment selling.”37 He argued that by hampering savings, America’s installment credit “retard[ed] the growth of its productive capital” and “morally … it loosened the restraint upon recklessness in optional expenditures.”

…

By enabling the demand for goods that consumers could not otherwise afford—or worse, for which they could budget installment payments but refused to save—installment credit encouraged overinvestment in productive capacity, which could be made profitable only by what The New York Times called the “continuing and increasing doses of the [installment credit] stimulant.”38 Unearned and not quite real, this “artificial stimulus” smacked of excess. As in the stock market bubble, there was only a symbolic value, not a real one. The shocking experience of the crash emerged from the economy’s very unreality. As the undersecretary of the Treasury wrote in 1932, the “sweeping decline was … inevitable” because “the country was living too much on credit.”39 The director of the Federal Reserve Bank of St. Louis, Max Nahm, argued that “if we could pay the debt of the world today, the depression would be over tomorrow.”40 Saving, not spending, would bring prosperity.

Stronger currencies meant higher production costs, especially with the heavy reliance on imported inputs from East Asia, as well as
reduced export price competitiveness, lower export growth and increased current
account deficits. Thus, the overvalued currencies became attractive targets for
speculative attacks, resulting in the futile, but costly defences of the Thai baht and
Malaysian ringgit, and the rapid regional spread of herd panic termed contagion.
The resulting precipitous asset price collapses – as the share and property market
bubbles burst – undermined the East Asian four’s heavily exposed banking
systems, for some (e.g. Malaysia), for the second time in little over a decade,
undermining financial system liquidity, and causing economic recession.
Undoubtedly, international financial liberalisation succeeded in temporarily
generating massive net capital inflows into East Asia, unlike most other developing and transitional economies, some of which experienced net outflows.

…

Notes
The percentages written in the graph are average annual rates of growth (the figure for Chile refers to
1975–80). 1, Chile; 2, Mexico; 3, Brazil and 4, Korea.
130
Gabriel Palma
A similar argument can be advanced for Mexico; although economic reforms
and NAFTA can, from the average investor’s point of view, justify some life in the
Mexican stock market, a 15-fold surge belongs to a different story – one of
a typical Kindlebergian ‘mania’. Again, the subsequent panic and crash are part
of the same story.20
As mentioned previously, Malaysia and Thailand did follow ‘route 1’ countries
in this respect, but their stock markets’ bubbles were small in comparison with
those of Chile or Mexico even if one compares the change between the lowest
quarterly point in these countries indices vis-à-vis the highest one – in Malaysia
the increase is 6-fold (between the second quarter of 1988 and the fourth quarter
of 1993), while in Thailand the corresponding jump is 5.4-fold (between the first
quarter of 1988 and fourth quarter of 1993).

Rolling betas should be
graphed to search for any patterns or systematic changes in a stock’s risk.
r Raw regressions should be based on monthly returns. Using more fre-
quent return periods, such as daily and weekly returns, leads to systematic biases.22
r Company stock returns should be regressed against a value-weighted,
well-diversified market portfolio, such as the MSCI World Index, bearing
in mind that this portfolio’s value may be distorted if measured during
a market bubble.
In the CAPM, the market portfolio equals the portfolio of all assets, both
traded (such as stocks and bonds) and untraded (such as private companies
and human capital). Since the true market portfolio is unobservable, a proxy
is necessary. For U.S. stocks, the most common proxy is the S&P 500, a valueweighted index of large U.S. companies. Outside the United States, financial
analysts rely on either a regional index like the MSCI Europe Index or the MSCI
World Index, a value-weighted index comprising large stocks from 23 developed countries (including the United States).
22 Using
daily or even weekly returns is especially problematic when the stock is rarely traded.

…

Metrick, “Corporate Governance and Equity Prices,” Quarterly Journal of Economics 118, no. 1 (2003): 107–155.
22 J. Comprix and K. A. Muller III, “Asymmetric Treatment of Reported Pension Expense and Income
Amounts in CEO Cash Compensation Calculations,” Journal of Accounting and Economics 42, no. 3
(December 2006): 385–416.
23 J. Coronado and S. Sharpe, “Did Pension Plan Accounting Contribute to a Stock Market Bubble?”
(mimeo, Board of Governors of Federal Reserve System, 2003).
CLOSING THOUGHTS 447
CLOSING THOUGHTS
Following the financial crisis of 2007–2009, global accounting bodies have
worked to close the distortions caused by off-balance-sheet obligations.
Although they have made progress, inconsistencies still exist, and careful digging is still required.
Thankfully, not every company will have these off-balance-sheet obligations.

—George Soros,April 2000
GLOBAL MACRO IS DEAD
As 1999 rolled into 2000, many other global macro funds also closed down,
prompting the popular press and Wall Street pundits to declare global macro
“dead.”While 2000 may have marked the end of the $20 billion-plus global
macro mega-funds, it was premature to cite the end of a strategy that profits from global misalignments and macroeconomic trends.
When the stock market bubble finally did burst in March 2000, the
Greenspan put was written once again as interest rates were reduced from
6.5 percent to 1 percent—levels not seen since the 1950s. It was in this
new paradigm that the up-and-coming crop of global macro managers
made their names. They caught not only the interest rate move, but also
other parts of the classic macro view at the time: long bonds, short stocks,
and eventually short the U.S. dollar.

…

On average, when there
46
INSIDE THE HOUSE OF MONEY
is a bad event, volatility goes up because everybody gets nervous and pays
up for insurance.
One thing the September 11 attacks did for me was reconfirm that tail
risk should not be allowed in your portfolio because things happen that
you can’t imagine.
I’ll give you an example that shows how serious I am about cutting off
tail risk. After the stock market bubble burst in 2000 and the Fed started
cutting rates, I thought there was a chance the United States could be
headed toward a Japan-like deflation situation. I bought butterfly option
structures on front-end interest rates whereby I bought one call struck at 2
percent yield and sold two times as many calls struck at 1 percent yield,
such that we’d make money if interest rates went anywhere from 2 percent
to zero.The option structure was very cheap and our biggest payout came
if rates stopped at 1 percent.

Mellon’s message was clear: government should just get out of the way.78 Regulation of private business, as espoused by Brandeis and Wilson, slipped out of fashion.79
The antiregulatory policies of the 1920s helped make possible a period of rampant financial speculation, driven by investment banks and closely related firms that sold and traded securities in an unregulated free-for-all. Investor protection was minimal; small investors could be lured into complex financial vehicles they didn’t understand, and were offered large margin loans to leverage their positions.80 While the market rose, everyone benefited. But the result was a stock market bubble fueled by borrowing and psychological momentum.81 Low interest rates set by the Federal Reserve also fueled an economic boom for much of the decade and encouraged increased borrowing by companies and individuals.82 By 1929, financial assets were at all-time highs, sustained by high levels of leverage throughout the economy. The stock market crash of October 1929 not only destroyed billions of dollars of paper wealth and wiped out many small investors; it also triggered an unprecedented wave of de-leveraging as financial institutions, companies, and investors sold anything they could in an attempt to pay off their debts, sending prices spiraling downward.83
The Federal Reserve could have slowed down the boom and avoided the sharp crash of 1929 if it had been willing early enough to “take away the punch bowl” (in the words of later Fed chair William McChesney Martin)84 by raising interest rates to discourage borrowing and slow down economic growth.

…

For their pains, the Rubin-Summers-Greenspan trio was featured on the cover of Time magazine as the “Committee to Save the World.”2
The second lesson was that while the U.S. economy was not completely immune to financial panics, any real damage could be contained through a few backroom deals. At the urging of the Federal Reserve, LTCM was essentially bought out and refinanced by a group of private sector banks, preventing a major crisis; a series of interest rate cuts by the Fed even kept the stock market bubble growing for another two years. The mature U.S. financial system, it seemed, could withstand any infection that might spread from the developing world, thanks to its sound financial system and macroeconomic management.
Crises were for countries with immature economies, insufficiently developed financial systems, and weak political systems, which had not yet achieved long-term prosperity and stability—countries like Thailand, Indonesia, and South Korea.

Little did most commuters know that on this day they would reach a market high not to be surmounted again for a quarter of a century. “Wall Street was pandemonium,” said Philip Gibb of the downtown scene that fall. “The outside brokers—the curb men—were bidding against one another for stocks not quoted on the New York Exchange, and their hoarse cries mingled in a raucous chorus. I stood outside a madhouse staring at lunatics.” The stock market bubble—once tethered on a long, thin string to reality far below—had come loose. At the closing bell, the Dow Jones Industrial Average was 381, compared to 104 five years earlier. In the last three months alone, average values had risen twenty-five percent.
For all the decade’s marvels and activity—the speed records, dancing contests, political ballyhoo, speakeasy raids, airplane crashes, and talking picture premieres—nothing captured the country’s attention like the market that day.

…

However, if the issue at stake is large, stay as long as the next man, but go ahead and do things.” Raskob lived his words to the end.
Like him, George Ohrstrom and Walter Chrysler went into the Depression facing a tough road ahead, but both managed to sustain themselves through the desperate times, although one had to give up ownership of his skyscraper.
In the crash, the boy wonder of Wall Street forfeited most of the water companies he had assembled during the market bubble, leaving him in a precarious financial position, but his voyage to Europe in the wake of Black Tuesday was a success, helping him to maintain the support of his investors. Once again he began acquiring small industrial businesses within a larger holding company. The market implosion taught him not to leverage his companies against one another. They had to stand on their own, or he was not interested in a relationship.

Votes against management, for example, may make it harder for fund managers to get information from a corporation or to win the right to advise its pension plan. Controversial votes may draw unwanted publicity.
By their long forbearance and lassitude on corporate governance issues, mutual funds bear no small share of the responsibility for the failures in corporate governance and accounting oversight that were among the major forces creating the stock market bubble of the late 1990s, and the (50 percent) bear market that followed.6 If the owners of our corporations don’t care about governance, who else is there to assume that responsibility?
The first step toward greater accountability is for mutual fund agents to disclose how they vote the shares they own on behalf of their shareholder principals. The time has long since come for funds to cease their passivity as corporate owners and to assume the important responsibilities of corporate citizenship.

…

For example, in the Go-Go Years of the late 1960s, some 350 new equity funds—largely highly volatile and risky “performance” funds—were formed, more than doubling the number of funds from 240 in 1965 to 535 in 1972. With the ensuing collapse of that bubble and the subsequent 50 percent decline in the overall stock market, only seven or eight new funds were formed during each year in the decade that followed. In the next marketing bubble—the rise of the Information Age, beginning in the late 1990s—funds focusing on Internet and high-tech stocks led the way. The fund industry responded just as one would expect a marketing business to respond. We created an astonishing total of 3,800(!) new equity funds, mostly aggressive growth funds focused on technology and the so-called new economy. Although some 1,200 funds went out of business during this period, the equity fund population still more than doubled, from 2,100 funds at the start of 1996 to 4,700 in 2001.

However, they'll often be carried out with an entirely different goal in mind--becoming independently wealthy and financially independent within five years.
The methods for doing so will be simple. I won't present any tips that haven't been seen before and which one can't find described in detail in hundreds of other books. Success won't depend on becoming famous on the Internet or getting a book deal, nor will it depend on a timely participation in a market bubble of junk bonds, internet companies, real estate, gold, or tulips. It also won't depend on successfully starting your own business. You won't need to develop a particular specialized skill such as real estate flipping. In fact, if you have a job, keep it. However, using the methods in a way that aligns your goals and side effects persistently and consistently to achieve financial or job-independence is not easy.

…

This is a genius insight, insofar as it renders the problem mathematically tractable, but it isn't technically true. It's similar to how the insight that gravity is a two-body force and that the gravitational force between the sun and each individual planet is much stronger than the force between the individual planets makes it possible to compute planetary motion. In astrophysics, this always holds true. In economics and investing, it only holds in most cases. When it doesn't, we have market bubbles and crashes. These occur when a substantial number of market participants start behaving according to how the market is behaving--that is, how they themselves are behaving. Their behavior becomes self-referential without them realizing it! In particular the problem is now that the average of all investors is so well tracked that a large fraction of the market responds to the average--and as it very often happens, decisions are strongly influenced by what can be measured, rather than what should be measured.

These stock promotions were all too often accompanied by fraud, as the temptation to make off with other people’s money became overwhelming. Anyone who wishes to understand this phenomenon should turn not to economic historians but to Dickens and, more specifically, Nicholas Nickleby (of which more in Chapter Five). There, he describes the flotation of a company whose promoters lure outsiders into a stock market bubble and discreetly take their leave before the whole thing pops.
While this nineteenth-century corporate party was already going with a swing, it enjoyed a further boost from generalised incorporation, which was introduced in English law along with limited liability under statute, in mid-century. The party was at its most frenetic in the rail industry, where George Hudson, known as ‘the railway king’, was the leading entrepreneur.

…

And in 1995 he clearly identified that the technology boom was turning into a bubble, telling the Fed’s main policymaking body, the Federal Open Market Committee, in May of that year, ‘The way I put it is that I am more nervous about the asset price bubble than I am about product prices.’ But he also worried that if the Fed pricked the bubble, it could ‘blow the economy out of the water’. At the September 1996 FOMC meeting, he said: ‘I recognise that there is a stock market bubble problem at this point … We do have the possibility of raising major concerns by increasing margin requirements. I guarantee that if you want to get rid of the bubble, whatever it is, that will do it.’
Later that year he made a speech in which he famously referred to ‘irrational exuberance’ in the stock market. Yet from then on he spent much time justifying the ever increasing level of the market by reference to a productivity miracle.

Within a few months after that, by July 1995, Greenspan was back to cutting rates, slashing the funds rate from 6 percent to 5.75 percent, flooding the economy with money at a time when the stock market was exploding. With easy credit everywhere and returns on savings and CDs at rock bottom, everyone and his brother rushed ass first into the tech-fueled stock market. “That’s the beginning of the biggest stock market bubble in U.S. history,” says Fleckenstein.
But Greenspan’s biggest contribution to the bubble economy was psychological. As Fed chief he had enormous influence over the direction of the economy and could have dramatically altered history simply by stating out loud that the stock market was overvalued.
And in fact, Greenspan in somewhat hesitating fashion tried this—with his famous December 1996 warning that perhaps “irrational exuberance” had overinflated asset values.

…

We can calculate how much money Greenspan dumped into the economy in advance of Y2K; between September 20 and November 10, 1999, the Fed printed about $147 billion extra and pumped it into the economy. “The crucial issue … is to recognize that we have a Y2K problem,” he said at the century’s final FOMC meeting. “It is a problem about which we don’t want to become complacent.”
Again, all of these rate cuts and injections—in response to LTCM, the emerging markets crash, and Y2K—were undertaken in the middle of a raging stock market bubble, making his crisis strategy somewhat like trying to put out a forest fire with napalm.
By the turn of the century, the effect of Greenspan’s constant money printing was definite and contagious, as it was now widely understood that every fuckup would be bailed out by rivers of cheap cash. This was where the term “Greenspan put” first began to be used widely.
Aside: a “put” is a financial contract between two parties that gives the buyer the option to sell a stock at a certain share price.

pages: 357words: 94,852

No Is Not Enough: Resisting Trump’s Shock Politics and Winning the World We Need
by
Naomi Klein

The main pillars of Trump’s political and economic project are: the deconstruction of the regulatory state; a full-bore attack on the welfare state and social services (rationalized in part through bellicose racial fearmongering and attacks on women for exercising their rights); the unleashing of a domestic fossil fuel frenzy (which requires the sweeping aside of climate science and the gagging of large parts of the government bureaucracy); and a civilizational war against immigrants and “radical Islamic terrorism” (with ever-expanding domestic and foreign theaters).
In addition to the obvious threats this entire project poses to those who are already most vulnerable, it’s also a vision that can be counted on to generate wave after wave of crises and shocks. Economic shocks, as market bubbles—inflated thanks to deregulation—burst; security shocks, as blowback from anti-Islamic policies and foreign aggression comes home; weather shocks, as our climate is further destabilized; and industrial shocks, as oil pipelines spill and rigs collapse, which they tend to do when the safety and environmental regulations that prevent chaos are slashed.
All this is dangerous. Even more so is the way the Trump administration can be relied upon to exploit these shocks to push through the more radical planks of its agenda.

…

Economic Shocks
Just as Trump could not be unaware that his anti-Muslim actions and rhetoric make terror attacks more likely, I suspect that many in the Trump administration are fully cognizant of the fact that their frenzy of financial deregulation makes other kinds of shocks and disasters more likely as well. Trump has announced plans to dismantle Dodd–Frank, the most substantive piece of legislation introduced after the 2008 banking collapse. Dodd–Frank wasn’t tough enough, but its absence will liberate Wall Street to go wild blowing new bubbles, which will inevitably burst, creating new economic shocks.
Trump’s team are not unaware of this, they are simply unconcerned—the profits from those market bubbles are too tantalizing. Besides, they know that since the banks were never broken up, they are still too big to fail, which means that if it all comes crashing down, they will be bailed out again, just like in 2008. (In fact, Trump issued an executive order calling for a review of the specific part of Dodd–Frank designed to prevent taxpayers from being stuck with the bill for another such bailout—an ominous sign, especially with so many former Goldman executives making White House policy.)

Far away across vast Saturn's curve, a roiling mushroom cloud of methane sucked up from the frigid depths of the gas giant's troposphere heads toward the stars.
"– Give him sixty-four doubling times, hmm, add a delay factor for propagation across the system, call it six light-hours across, um, and I'd say … " she looks at Sirhan. "Oh dear."
"What?"
The orang-utan explains: "Economics 2.0 is more efficient than any human-designed resource allocation schema. Expect a market bubble and crash within twelve hours."
"More than that," says Amber, idly kicking at a tussock of grass. She squints at Sirhan. "My mother is dead," she remarks quietly. Louder: "She never really asked what we found beyond the router. Neither did you, did you? The Matrioshka brains – it's a standard part of the stellar life cycle. Life begets intelligence, intelligence begets smart matter and a singularity.

…

It plants a spun-diamond glass in front of Gianni, then pukes beer into it. Manfred declines a refill, waiting for Gianni to drink. "Ah, the simple pleasures of the flesh! I've been corresponding with your daughter, Manny. She loaned me her experiential digest of the journey to Hyundai +4904/-56. I found it quite alarming. Nobody's casting aspersions on her observations, not after that self-propelled stock market bubble or 419 scam or whatever it was got loose in the Economics 2.0 sphere, but the implications – the Vile Offspring will eat the solar system, Manny. Then they'll slow down. But where does that leave us, I ask you? What is there for orthohumans like us to do?"
Manfred nods thoughtfully. "You've heard the argument between the accelerationistas and the time-binder faction, I assume?" he asks.
"Of course."

However, if you take the word “responsibly” out of that sentence, it does become a bad thing.
Simon Johnson, former chief economist for the International Monetary Fund, wrote an excellent postmortem of the financial crisis for The Atlantic in 2009. He notes, “Major commercial and investment banks—and the hedge funds that ran alongside them—were the big beneficiaries of the twin housing and equity-market bubbles of this decade, their profits fed by an ever-increasing volume of transactions founded on a relatively small base of actual physical assets. Each time a loan was sold, packaged, securitized, and resold, banks took their transaction fees, and the hedge funds buying those securities reaped ever-larger fees as their holdings grew.”12
Each transaction carries some embedded risk. The problem is that the bankers making huge commissions on the buying and selling of what would later become known as “toxic assets” do not bear the full risk of those products; their firms do.

…

Think of the Fed as always driving in unfamiliar terrain with a map that’s at least ten years out of date.
Bob Woodward’s biography of Alan Greenspan was titled Maestro. In the 1990s, as the American economy roared through its longest expansion in economic history, Mr. Greenspan was given credit for his “Goldilocks” approach to monetary policy—doing everything just right. That reputation has since come partially unraveled. Mr. Greenspan is now criticized for abetting the housing and stock market bubbles by keeping interest rates too low for too long. “Cheap money” didn’t cause inflation by sending everyone to buy PT Cruisers and Caribbean cruises. Instead we bought stocks and real estate, and those rising asset prices didn’t show up in the consumer price index. Add one new challenge to monetary policy: We were speeding even though the gauges we’re used to looking at said we weren’t.
It’s a hard job.

The three main channels through which quantitative easing helped the economy were all weak: a slight weakening of the value of the dollar helped exports—but these effects were eventually countervailed by America’s trading partners; mortgage rates were reduced as long-term interest rates fell, but the monopolistic banks—and bank concentration after the crisis was greater than before—took much of the lower interest rates and simply enjoyed it as extra profits; and the stock market bubble led the very rich to consume a little more, especially of luxury goods, many of which were made abroad. What the economy really needed was more lending to businesses, but big businesses were already sitting on $2 trillion of cash and were essentially unaffected by QE. And because the Fed and the Obama administration had fixed their attention on the big New York banks and other international banks, the ability of the smaller regional and community banks to make loans remained impaired.43 The result was that years after the crisis such lending remained before its precrisis level.

Pensions, other real money investors, and retail investors all made money in this environment. It was a wonderful time to be invested (see Figure 1.5).
The Dot-Com Crash
As real money was becoming increasingly loaded up on equity risk in their 60-40 portfolios (stocks can be anywhere from 2 to 10 times riskier than bonds depending on what proxies are used), two decades of declining inflation and interest rates culminated in a technology-led stock market bubble that finally popped in March 2000. After the peak, global equity markets declined relentlessly year after year, finally bottoming in early 2003. Stocks generally lost half their value while in-vogue technology stocks dropped 75 percent from peak to trough (see Figure 1.6). Just as they had in the 1970s with bonds, real money managers became painfully aware of the equity concentration risk in their portfolios and began to look for a better, less risky approach.

GPRA required agencies to formally define their mission and to develop strategic plans to achieve those missions. The General Accounting Office (GAO) was assigned the task of identifying high-risk government activities.
The SEC, for example, properly defines itself in its recent strategic plans as “a civil law enforcement agency” (SEC Annual Report for 2002, 1). The SEC’s annual reports during the 1990s, however, despite the record-setting, inflating stock market bubble, never defined a wave of control fraud as a central risk to the accomplishment of its mission. The SEC had grossly inadequate resources, did not see the wave of control frauds coming, and was overwhelmed. The GAO’s definition of high-risk functions includes fraud risk as a key factor. The GAO, however, limited its concept of fraud risk to situations in which someone was stealing from a public agency.

…

Without Gray’s war on the control frauds, their growth would have increased throughout his term. His successor, Danny Wall, would not have taken on the control frauds for reasons made clear later in this book. Indeed, he helped the most notorious control fraud escape regulatory control. Eventually, the expanding wave of control fraud would have caused such a massive bubble in real estate values that it would have collapsed. Since Japan’s real estate and stock market bubbles grew for a full decade during the 1980s without the growth advantages provided by deposit insurance, a U.S. bubble could have lasted for over a decade. Therefore, the wave of control fraud could have extended throughout the Reagan and Bush administrations had it not been for Gray’s desperate war against the control frauds.
There were over 300 control frauds. My study found that the 11th District (California, Arizona, and Nevada) had 58 control frauds (Black 1998).

Instead these negative external events combined with the maturing of
the economy to push Hawai‘i into stagnation. Being open to the rest of
the world means being vulnerable to events outside your control. The Gulf
War was one of these events, a conflict on the other side of the world that
had real and immediate effects on Hawai‘i’s economic fortunes. The slide
of the mainland economy into recession, followed by the bursting of Japan’s
stock and property market bubbles brought Hawai‘i’s economic growth to
zero.
Hawai‘i residents initially reacted to the stagnation with blame and denial.
Perhaps that is a natural reaction to events that suggest the necessity to
reevaluate long-cherished policies. The disappearance of accumulated balances in the state general fund signaled the severity of the downturn. Cries
that government had become too big grew louder and more frequent.

The American people were furious: 70 percent of them said that they did not trust what their brokers or corporations told them and 60 percent called corporate wrongdoing “a widespread problem.”32 Even bosses who had not been caught doing anything wrong, such as Hank Paulson of Goldman Sachs and Andy Grove of Intel, felt obliged to apologize to the public for the sorry state of American capitalism.33 Meanwhile, in continental Europe, the two bosses who had most obviously proclaimed themselves disciples of the American way—Thomas Middelhoff of Germany’s Bertelsmann and Jean-Marie Messier of France’s Vivendi—were both sacked.
The general catalyst for this revolution was the bursting of America’s stock-market bubble. Between March 2000 and July 2002, this destroyed $7 trillion in wealth—a sum equivalent to a quarter of the financial assets owned by Americans (and an eighth of their total wealth). The spread of mutual funds and the change from defined-benefit to defined-contribution retirement plans meant that this was a truly democratic crash: most of the households in America lost money directly.
The specific catalyst was, ironically enough, one of the firms that Bush had turned to to design his energy policy.

Whatever your interest in the subject – as a manager of other
people’s wealth or an individual saver seeking to protect and maintain their own
assets – this handbook offers vital insights into how to manage wealth better in
uncertain times. And uncertainty is the key characteristic the new financial world
order. Recent months have seen unprecedented shifts in the economy and in the
financial services sector in particular. After a decade or more of growth, came the
nasty shock of the most dramatic financial collapse in living memory and nothing
will look the same again.
Within a few months, both housing and stock market bubbles have burst. In the
process the entire global banking system almost came down with them. Those who
have worked hard to build wealth and secure their future were left uncertain of
where and how to find the right balance of risk and return. The game has changed,
but no one is entirely sure of the new rules.
Old certainties have gone forever. Previously secure investments have collapsed
in value, trusted investors have been exposed as fraudulent and many investors and
savers feel let down and many more face an uncertain future.

But rather than dwell only on what went wrong, consider what you may have inadvertently discovered.
Avoid the Trap of Visionary’s Narcissism
During my time at Goldman Sachs, I had the opportunity to be a fly on the wall in a lot of meetings in the executive office during both the dot-com bubble and the dire period that followed it. I always found it interesting how every challenge was presented as an unusual one-off: “Never before have we had a market bubble, followed by such volatility in interest rates, interspersed with terrorist concerns.” The business leaders would nod their heads in affirmation. “This is an extraordinary time,” someone else would say.
Based on all the times I have heard “This is the most unusual X, the greatest period of Y, the new era of Z,” you might think that had I not been born in the last thirty years I might have missed the most exciting years of business since the beginning of time!

Here are a few others:
Between 2007 and 2008, more than 800,000 additional American households found themselves trying to make do on under $25,000 a year, bringing the total to nearly 29 million.24
In 2005, households in the bottom 20 percent had an average income of $10,655, while the top 20 percent made $159,583—a disparity of 1,500 percent, the highest gap ever recorded.25
In 2007, the top 10 percent pocketed almost half of all the money earned in America—the highest percentage recorded since 1917 (including, as Business Insider editor Henry Blodget noted, in 1928, the peak of the stock market bubble in the “roaring 1920s”).26
Between 2000 and 2008, the poverty rate in the suburbs of the largest metro areas in the United States grew by 25 percent—making the suburbs home to the country’s biggest and most rapidly expanding segment of the poor.27
Making matters even worse is the fact that while the classes are moving farther apart—with the middle class in real danger of disappearing entirely—mobility across the classes has declined.

Financial crises of one sort or another, which affected companies ranging from Japanese and Swedish banks to Long Term Capital, an American hedge
fund, continued to occur. In fact, they became more frequent. However, the
US Federal Reserve and Treasury were always quick to ﬂood the market with
money and slash interest rates in order to limit the damage to the ﬁnancial
17
18
Chapter 1 | The Rise and Fall of the Finance-Driven Economy
economy. Except for the collapse of the dot-com stock market bubble, largescale destruction of ﬁnancialized wealth was a thing of the past.
Another problem, of course, is that markets are reﬂections of human nature,
balanced on a knife’s edge between fear and greed. To remove fear is to open
the ﬂoodgates of greed. The problem with greed, whatever the Occupy Wall
Street gang might think, is not that it is bad. There is bad and greed in all of
us. The problem with greed is that it is careless and often delusional.

It would be good to repeat this, but I suspect it won’t happen. The next time our unemployment rate gets near 4 percent, the Federal Reserve is more likely to slam on the brakes by raising interest rates. In the late 1990s, Fed chair Alan Greenspan held interest rates low despite opposition from other Fed board members who worried about potential inflationary consequences of rapid growth, rising wages, and the Internet stock market bubble. Greenspan’s belief in the self-correcting nature of markets led him to worry less than others. Given the painful consequences of the 2000s housing bubble, the Fed is highly unlikely to repeat that approach.
So for Americans in middle- and lower-paying jobs, prospects for rising wages going forward are slim.
Employment is the other potential source of rising earnings. Indeed, as I noted in chapter 2, it’s the chief reason there has been any increase at all in household incomes since the 1970s.

Top-earning Americans hadn’t had it so good since before the
ﬁrst Wall Street crash in 1929. Based on market income, including
wages, bonuses, dividends, and pensions, Berkeley economist Emmanuel Saez calculated the changing fortunes of America’s top earners since
1917. He shows that the top 10 percent received almost half (49.7%)
of national individual income in 2006, surpassing 1928, the peak of the
stock market bubble in the Roaring ’20s.8 If the top 10 percent have
done well over the last 25 years, it is those at the very top who struck
gold. Saez’s evidence shows that the top 1 percent captured about half
of the overall economic growth in America over the period 1993 to
2006. These were the working rich, including the CEOs of major
corporations. In 1965, American CEOs earned 24 times more than
the typical worker; the ratio grew to over 100 by in the early 1990s
and stood at 1:275 in 2007.

In technology and business, revolutions tend to play out in evolutionary steps, over time. Technical innovation is only one piece of a puzzle that includes affordability, acceptance in the marketplace, and changes in behavior. Recall that nearly all of the bold predictions made in the late 1990s about the disruptive impact of the Internet across industry really did come true—a decade later, long after the Internet stock-market bubble had burst.
All successful technologies raise alarms and involve trade-offs and risks. In ancient times, fire could cook your food and keep you warm, but, out of control, could burn down your hut. Cars pollute the air and cause traffic deaths, but they have also increased personal mobility and freedom, and stimulated the development of regional and national markets for goods. The outlook for the technology we call big data is not fundamentally different.

It seems to me
that Wall Street management reached into the pockets of their
shareholders and paid big ﬁnes so they could keep the status
quo. I have a bad feeling that Spitzer’s “settlement” will merely
perpetuate the old way of doing business much longer than its
natural life. The structural changes and return of tough ﬁlters
will take longer and be more painful to fulﬁll.
Is there some message to all this? Some note to future generations about how to avoid stock market bubbles, how to keep
research honest, how to tame the cycles? Nah. They will learn
230
Spitzer Fixer
it the hard way. Wall Street is a business. Analysts and salesmen
and traders and bankers all make a living providing access to
capital to businesses worldwide. For that task, the Street, as a
group, gets to keep half of all the revenues they generate. But
it’s an information business. When you work on the Street, all
you have is your reputation.

It proposed raising the official figure
from 14.7 million to at least 37.1 million, although it acknowledged that
this revision still failed to include tens of millions of laid-off employees
or the 100 million "floating workers" still counted as farmers.68
Urban poverty in India is more honestly acknowledged and publicly
debated than in China, but local social scientists and social-justice
activists trying to focus public attention on the underside of the recent
economic growth have also had to swim against the current of celebratory official rhetoric As any reader of the business press knows, the
drastic neoliberal restructuring of the Indian economy after 1991
produced a high-tech boom and stock-market bubble whose frenzied
epicenters were a handful of Cinderella cities: Bangalore, Pune,
Hyderabad, and Chennai. GDP grew at 6 percent during the 1990s,
while the capitalization of the Bombay Stock Exchange doubled almost
every year — and one result was one million new millionaires, many of
them Indian engineers and computer scientists returned from Sunnyvale
67 Yatsko, New Shanghai, pp. 120-21.
68 People's Daily (English version), 30 October 2002; Athar Hussain, "Urban
Poverty in China: Measurement, Patterns and Policies," ILO working paper, Geneva
2003.

The banks do this both in the form of residential property markets, but also by financing and investing in commercial property. Even in the cases where the banks only act as a facilitator and pass on the principal risks to other investors (as opposed to other cases where banks hold on to a property investment), they still have a huge interest in a positive property market.
The bursting of the US sub-prime market bubble in 2007–08 and the subsequent default of many geared products connected to it was one of the primary drivers of the financial crisis. So even if the direct representation of property investment companies represents a fairly small portion of the overall stock market, we have indirect exposure to property through many other sectors of the stock markets. In addition to the banks, the listing of many large infrastructure and construction-related companies further adds to our indirect exposure to the property market because corporations in a wide variety of industries already are the largest holders of commercial property.3
Some might disagree that I’m leaving out property investments and I can appreciate why.

. . . When everyone is looking to
someone else for an opinion—trying, for example, to
pick the Democratic candidate they think everyone else
will pick—it’s possible that whatever information other
people might have gets lost, and instead we get a cascade
of imitation that, like a stampeding herd, can start for no
apparent reason and subsequently go in any direction
with equal likelihood. Stock market bubbles and cultural
fads are the examples that most people associate with
cascades . . . but the same dynamics can show up even in
the serious business of Democratic primaries. . . . We
think of ourselves as autonomous individuals, each
driven by [our] own internal abilities and desires and
therefore solely responsible for our own behavior,
particularly when it comes to voting. No voter ever
admits—even to herself—that she chose Kerry because
he won New Hampshire.65
Cascades can be found for many contested political
questions, including the legitimacy of affirmative action,
Four Big Problems / 99
abortion, preemptive war, and capital punishment.

U.S. home prices had recently increased by another 15 percent in a year, and they had almost doubled since the turn of the millennium. To return to the trends they had followed in the 30 years before that, they would have to fall by around one-fifth. But the builders' associations and the banks' magazines explained soothingly that home prices never fall nationally. This did not impress James Grant, who noted that, since the Great Depression, the United States had experienced 29 market bubbles-strong rises in the prices of securities or other assets. Twentyseven of them had burst. The two exceptions were stock and realestate prices in June 2005. Not understanding why bubbles no. 28 and no. 29 should be exceptions, Grant gave his readers some good advice:
Does your brother-in-law, the real estate broker, owe you money? Now is the time to collect.'
The Fed Is Our Friend
When Alan Greenspan left the Fed in January 2006, The Economist warned that the popularity he had garnered from recurrent rescue efforts such as the aggressive interest-rate cut after 2001 was the most dangerous of his legacies:
Investors' exaggerated faith in his ability to protect them has undoubtedly encouraged them to take ever bigger risks and pushed share and house prices higher.

But economics is not an exact science so I could not give the diplomat a precise date for when the boom would end; just the certainty that a turning point would come and it would be sooner than he thought.
By mid-2007, two events had taken place, in quick succession, which indicated that the global economy was changing direction. The first occurred in the autumn of 2006 when the US housing market bubble burst; this was followed by the collapse on the Shanghai stock market in February 2007. These events were, at the time, viewed as isolated incidents, unconnected to the larger web of the global economy. During the Great Moderation, words like capitalism and business cycles were no longer a part of the vocabulary of modern economics used by self-respecting economics departments. Perhaps because of this, when the crisis finally hit, its severity took some time to register.

As John Kenneth Galbraith observed: ‘[T]he rich were getting richer much faster than the ‌poor were getting less poor.’15
With the buying power of workers severely constrained, wealthy Americans happily turned their capital over to Wall Street for lucrative financial speculation. In 1926, Republican Treasury Secretary Andrew Mellon, the fifth richest man in the US, introduced an enormous tax cut for the rich. This provided the elite with a massive windfall that quickly flowed to Wall Street, inflating the stock market bubble. When that bubble burst in an orgy of unregulated financial speculation three years later, the resulting crash plunged the American economy into a deep depression with unemployment levels rivalling those in 1930s Britain.
But, as in Britain, the harsh experience of the 1930s in America prompted a demand for significant changes that led to greater equality. America didn’t go as far as Britain in embracing the welfare state, but it did make some important moves in that direction under Franklin Roosevelt’s Democratic administration.

But the upheaval was far from over, and the market remained in a nervous mood, partly due to uncertainty over the outcome of the United States and British invasion of Afghanistan a few weeks after 9/11. Then, in November, an energy trading company called Enron stuck a pin in the remains of the late 1990s stock-market bubble, which had shrunk but not burst. As the Justice Department moved in, Enron melted into bankruptcy in the heat of an accounting fraud.
Enron was an extreme but not isolated situation. The excesses of the stock-market bubble and the opportunity for executives to pillage their companies led to a whole series of accounting-fraud and securities-violation cases: WorldCom, Adelphia Communications, Tyco, ImClone. As 2002 began, New York Attorney General Eliot Spitzer mounted a blitzkrieg assault against the Wall Street banks for having inflated stock prices by touting new offerings during the Internet bubble using biased stock research.18 Valuations of stocks and bonds began to fall apart as investors lost confidence in the numbers reported to them by managements.

…

In a sense, the Sun was one of his cigar butts, from which he had been able to enjoy one huge personal puff.
In another sense, the temporary boost of fame he had gotten from the Sun was a sidebar compared to something else. Buffett had recently exploded in investors’ minds for a different reason. Under the pen name Adam Smith, a writer named George Goodman had published Supermoney, a fire-and-brimstone critique of the 1960s stock-market bubble, which sold more than a million copies.53 It demonized the fund managers who had ascended to the stratosphere almost overnight and then crashed, in a parabola as dramatic as if their engines had suddenly run out of rocket fuel. They were featured as devil-horned, pitchfork-bearing tempters of the ordinary Joe Investor. But when it came to Ben Graham and his protégé Buffett, Goodman knew he had met a couple of very different characters, and he devoted an entire chapter to the two of them, in which he captured them brilliantly.

…

Trees don’t grow to the sky, he always said; as Berkshire’s capital grew, the climb would get steeper. But investors in Berkshire had only gratitude for the “lower” returns. Those who bought an index of the market had just suffered through what the Wall Street Journal called a “lost decade” in which the S&P 500 index had gone exactly nowhere, falling below its level of April 1999.2 Buffett’s talk at Sun Valley was unfolding along the lines he had discussed; the period after the 1999 stock market bubble had burst was now the third-longest stretch in the past hundred years when the market made no progress. Buffett still said that stocks are the best long-time investment—as long as they were bought at the right price, and for a low fee. As of early 2008, he was buying stocks, but not with great enthusiasm. Sooner or later the market’s weighing machine would catch up with its voting machine. In the meantime, he continued to mostly buy businesses.

During the 1980s, the value of private wealth shot up in Japan from slightly more than four years of national income at the beginning of the decade to nearly seven at the end. Clearly, this enormous and extremely rapid increase was partly artificial: the value of private capital fell sharply in the early 1990s before stabilizing at around six years of national income from the mid-1990s on.
I will not rehearse the history of the numerous real estate and stock market bubbles that inflated and burst in the rich countries after 1970, nor will I attempt to predict future bubbles, which I am quite incapable of doing in any case. Note, however, the sharp correction in the Italian real estate market in 1994–1995 and the bursting of the Internet bubble in 2000–2001, which caused a particularly sharp drop in the capital/income ratio in the United States and Britain (though not as sharp as the drop in Japan ten years earlier).

…

If certain immaterial investments (such as expenditures to increase the value of a brand or for research and development) are not counted on the balance sheet, then it is logical for the market value to be structurally greater than the book value. This may explain the ratios slightly greater than 1 observed in the United States (100–120 percent) and especially Britain (120–140 percent) in the late 1990s and 2000s. But these ratios greater than 1 also reflect stock market bubbles in both countries: Tobin’s Q fell rapidly toward 1 when the Internet bubble burst in 2001–2002 and in the financial crisis of 2008–2009 (see Figure 5.6).
Conversely, if the stockholders of a company do not have full control, say, because they have to compromise in a long-term relationship with other “stakeholders” (such as worker representatives, local or national governments, consumer groups, and so on), as we saw earlier is the case in “Rhenish capitalism,” then it is logical that the market value should be structurally less than the book value.

…

In short, it seems unreasonable to draw such an extreme contrast between Gates and Slim without so much as a glance at the facts.20
As for the Japanese billionaires (Yoshiaka Tsutsumi and Taikichiro Mori) who from 1987 to 1994 preceded Bill Gates at the top of the Forbes ranking, people in the Western world have all but forgotten their names. Perhaps there is a feeling that these men owe their fortunes entirely to the real estate and stock market bubbles that existed at the time in the Land of the Rising Sun, or else to some not very savory Asian wheeling and dealing. Yet Japanese growth from 1950 to 1990 was the greatest history had ever seen to that point, much greater than US growth in 1990–2010, and there is reason to believe that entrepreneurs played some role in this.
Rather than indulge in constructing a moral hierarchy of wealth, which in practice often amounts to an exercise in Western ethnocentrism, I think it is more useful to try to understand the general laws that govern the dynamics of wealth—leaving individuals aside and thinking instead about modes of regulation, and in particular taxation, that apply equally to everyone, regardless of nationality.

As in all areas of tax and regulatory policy, circumvention is a problem, and a key challenge for government is to outsmart such attempts by corporations.
14. See U.S. Census Bureau website, “U.S. International Trade in Goods and Services Highlights,” February 10, 2012, http://www.census.gov/indicator/www/ustrade.html (accessed March 6, 2012).
15. In the 1990s, we maintained a trade deficit and full employment, even with a government surplus; but the circumstances were unusual—an investment burst fueled by a stock market bubble (the tech bubble). And it was not sustainable. In chapter 8 we explained how one could stimulate the economy even within the confines of a limited budget deficit, but the politics of what is required (under current circumstances) may make even this unachievable.
16. Part of the reason for the trade imbalances is the role of the United States as a reserve currency. Others want to hold dollars as backing for their country and their currency.

The second claim of efficient-market hypothesis, what Thaler refers to as the Price Is Right component, is more dubious. Examples like the discrepancy in pricing between Palm and 3Com stock simply could not have arisen if the price were right. You had the same commodity (the value of an interest in Palm) trading at two different and wildly divergent prices: at least one of them must have been wrong.
There are asymmetries in the market: bubbles are easier to detect than to burst. What this means is that the ultimatum we face in Bayesland—if you really think the market is going to crash, why aren’t you willing to bet on it?—does not necessarily hold in the real world, where there are constraints on trading and on capital.
Noise in Financial Markets
There is a kind of symbiosis between the irrational traders and the skilled ones—just as, in a poker game, good players need some fish at the table to make the game profitable to play in.

But my concern about a bubble had changed my mind. I told the committee we might need an interest rate increase to try to rein in the bull. "We
have to start thinking about some form of preemptive move," I said, "and
how to communicate that."
I was choosing my words very carefully because we were on the record
and we were playing with political dynamite. The Fed has no explicit mandate under the law to try to contain a stock-market bubble. Indirectly we
had the authority to do so, if we believed stock prices were creating inflationary pressures. But in this instance, that would have been a very hard
case to make because the economy was performing so well.
The Fed does not operate in a vacuum. If we raised rates and gave as a
reason that we wanted to rein in the stock market, it would have provoked
a political firestorm. We'd have been accused of hurting the little investor,
sabotaging people's retirements.

…

The boom rose to a crescendo late in the year, with the NASDAQ
stock-market index at the end of December having nearly doubled in
199
More ebooks visit: http://www.ccebook.cn ccebook-orginal english ebooks
This file was collected by ccebook.cn form the internet, the author keeps the copyright.
T H E AGE OF T U R B U L E N C E
twelve months (the Dow rose 20 percent). Most people who'd invested in
stocks were feeling flush, and with good reason.
This presented the Fed with a fascinating puzzle:
How do you draw the line between a healthy exciting economic boom
and a wanton, speculative stock-market bubble driven by the less savory
aspects of human nature? As I pointed out drily to the House Banking
Committee, the question is all the more complicated because the two can
coexist: "The interpretation that we are currently enjoying productivity
acceleration does not ensure that equity prices are not overextended." An
example that intrigued me was the epic, multibillion-dollar competition
involving Qwest, Global Crossing, MCI, Level 3, and other telecom companies.

Capital and currency markets exhibit other indicia of complex systems. Emergent properties are seen in the recurring price patterns that technicians are so fond of. The peaks and valleys, “double tops,” “head and shoulders” and other technical chart patterns are examples of emergence from the complexity of the overall system. Phase transitions—rapid extreme changes—are present in the form of market bubbles and crashes.
Much of the work on capital markets as complex systems is still theoretical. However, there is strong empirical evidence, first reported by Benoît Mandelbrot, that the magnitude and frequency of certain market prices plot out as a power-law degree distribution. Mandelbrot showed that a time series chart of these price moves exhibited what he called a “fractal dimension.” A fractal dimension is a dimension greater than one and less than two, expressed as a fraction such as 1½; the word “fractal” is just short for “fractional.”

In order to sterilize without making huge losses, the PBOC fixes the economywide interest rate at a lower level than the dollar interest rate, both by forcing banks to pay households a low rate on their deposits and by paying a low rate on its own borrowing.
A direct effect of such a policy is that China mirrors the United States’ monetary policy. If interest rates in the United States are very low, China also has to keep interest rates low. Doing so risks creating credit, housing, and stock market bubbles in China, much as in the United States. With little freedom to use interest rates to counteract such trends, the Chinese authorities have to use blunt tools: for example, when credit starts growing strongly, the word goes out from the Chinese bank regulator that the banks should cut back on issuing credit. Typically, private firms without strong connections bear the brunt of these credit crunches.

But the CDS market was, as we now well know, egregiously mispriced by the humans who traded the swaps and set the prices. Nevertheless, Wall Street embraced Li’s formula as stone-solid fact. The copula should have been one arrow in the quiver of analysts and rating agencies who examined and stamped their approval on mortgage-backed securities. Instead, it became the only arrow.
The resultant boom in collateralized debt obligations and the housing market bubble came straight from bankers’ misuse of what should have been a harmless algorithm. Gaussian copulas are useful tools and are utilized in a number of fields, but the one thing they do not do is model dependence between extreme events, something humans excel at precipitating.33
PASCAL, BERNOULLI, AND THE DICE GAME THAT CHANGED THE WORLD
Much of modern finance, from annuities to insurance to algorithmic trading, has roots in probability theory—as do myriad other businesses from casinos to skyscraper construction to airplane manufacturing.

The most important factor for their remuneration and career
prospects is their willingness and ability to tell retail customers a story
that entices them to do business with their employer. For analysts who
cover stocks that have been underwritten by their employer, their career
outcome depends even more on that optimism than on the accuracy
of earnings forecasts. In a hot stock market, the reward for optimism
is highest. This implies that banks systematically amplify stock market
bubbles by having their analysts cheer on the retail investor crowds
(Kubik and Hong 2003).
The incentives of the analysts and their employers are not a secret to
the companies covered by their research: if analysts treat them well, these
companies return the favor. The gift exchange between analyzed companies
and analysts consists mostly of privileged access to information in exchange
for favorable reports.

Days that would be full of sunshine for him. And happiness. Future days that would be really cool.
The guy was light and magic.
Tony silently reached to pour himself more booze. The happy moment passed quickly. There was an anvil on Tony’s back.
“What are you up to, Tony? You got plans to turn it around, right?”
“Well,” said Tony, who was definitely not okay, “you mustn’t lose sight of the end goal, Van. After a stock market bubble, people are just as irrational as they were before. But now it’s all about the terror, instead of all about the greed. They are more irrational now, because they can’t see any future.”
“You’ve got money troubles?”
“It’s not that simple. By the way, I’m really sorry about your board of directors gig for DeFanti’s holding company. You were right to resign before you turned fed, but, well, I wanted to make that thing work out a lot better for you.”

It, and programmes like it, were exactly the ‘overspending’ for which Labour was calumnified during and after the May 2010 election. This, however, was not overspending; it was under-taxing. That did not necessarily mean higher income tax. With courage, Labour might have grappled with wider gaps in the British fiscal system, notably our failure fairly to tax property and wealth. Labour missed a cure: taxes on above-average value properties might have prevented the housing market bubbling into excess. Labour turned away from proper taxation of inheritance, even as a device to pay for the growing cost of social care for older people. The Cameron government attacks Labour for spending the nation into deficit, but a fairer charge is that fiscal cowardice disrupted the sustainability of very necessary spending.
Under a new leader, however, Labour has the chance to think again. As we write this, the polls, if not unambiguous, give Labour grounds to hope they can return to power.

Some urged caution, saying that China was still a relatively poor country, with an income level that was only 20% of that of the US, but most others were confident that China would do as well in finance as in manufacturing, where its ascendancy seemed unstoppable.Wang Xing-Guo, the pro-liberalization governor of the People’s Bank of China, the central bank (granted full independence in 2017), summed up this optimism perfectly: ‘What are we afraid of? The money game is in our genes – after all, paper money is a Chinese invention!’When it joined the organization in 2024, China revalued its currency, the renminbi, by four times and fully opened its capital market. For a while, the Chinese economy boomed as though the sky was the limit. But the resulting real estate and stock market bubbles burst in 2029, requiring the largest IMF rescue package in history.
Soaring unemployment and IMF-imposed cuts to government food subsidies led to riots and eventually to the rise of the Yuan-Gongchandang (Real Communist) movement, fuelled by the seething resentment of the ‘losers’ in a society that had moved from the near-absolute equality of Maoist communism to Brazilian-style inequality in the space of less than two generations.

On October 12, at the market bottom, the Elves were bearish, when they should have been bullish, and remained bearish through November 1994 as a powerful advance began. It became so embarrassing that Rukeyser actually replaced five bearish Elves with five more bullish Elves. Unfortunately, the newly organized Elves were bullish all through the bear market plunge (21 percent) in July and August of 1998.
A year later, as the stock market bubble was approaching its climax at the end of 1999, only one Elf, Gail Dudack, was correctly bearish. Rukeyser must have gotten tired of her bearishness and announced Dudack's dismissal on a November show. He replaced her with Alan Bond, another stock market bull (sentenced in 2003 to 12 years and 7 months in prison for defrauding investors). Two months later, the three-year bear market began with all 10 market-timing Elves bullish.

Usi had essentially built a big red ejector-seat button for Barclays’ trading desk, and while he might have insisted to colleagues that pressing the button was “amoral,” others sitting in his seat later on did not feel the same way.
Sue the Asshole
In early 2001, Usi’s securitization pipeline was on track to issue $15 billion of CDOs by the end of that year. But there were some troubling headwinds. With the bursting of the dot-com equity market bubble, investors were growing skittish. But Usi was becoming more dependent than ever on Barclays’ weak sales force to sell his Roman androids in order to lock in his profits.
Meanwhile, Barclays’ infrastructure had failed to keep up with the rising complexity of Usi’s deals. Agreements by the sales force with shady brokers like A.B. Finn (which subsequently went out of business) to bring in unsophisticated clients raised warning flags.

Maybe they are right. One cannot decisively prove that the stock market has been irrational. But in all of this debate no one has offered any real evidence to think that the volatility is rational.6
The price changes appear instead to be correlated with social changes of various kinds. Andrei Shleifer and Sendhil Mullainathan have observed the changes in Merrill Lynch advertisements. Prior to the stock market bubble, in the early 1990s, Merrill Lynch was running advertisements showing a grandfather fishing with his grandson. The ad was captioned: “Maybe you should plan to grow rich slowly.” By the time the market had peaked around 2000, when investors were obviously very pleased with recent results, Merrill’s ads had changed dramatically. In one of these was a picture of a computer chip shaped like a bull.

The losses incurred by British and
European banks, for example, arose initially largely from reckless investment in
securities backed by US subprime mortgages.
Despite the bubbles that were building across a number of markets, the regulatory
authorities took no action. Yet there had been plenty of earlier examples of their
destructive power. In the 1920s, it was the property followed by the stock market
bubble that led to the 1929 Crash. In the early 1970s, Heath’s freeing up of the banks
had provided a classic warning sign of the impact on property markets as house prices
surged out of control. The bursting of the Japanese property bubble in 1989—which
sent the nation into a decade-long spiral of deflation—was another.
In the US, Alan Greenspan had long argued that the role of the Federal Reserve was
to prevent consumer price inflation, and had no role when it came to inflation in the
price of assets.

Engage was part of a conglomerate of Internet companies—ranging from search engines AltaVista and Lycos to websites Shopping.com and Furniture.com—that resulted from a buying spree by the entrepreneur David Wetherell. In the fall of 1999, Wetherell appeared on the cover of BusinessWeek under the headline “Internet Evangelist.” His conglomerate, CMGI, was a poster child for the dot-com boom, with a massive stock market value of $10 billion, despite the fact that it was losing $127 million a year on revenues of just $176 million.
By 2001, the dot-com stock market bubble had burst. CMGI’s losses had reached $1 billion a quarter and its stock plummeted to less than $1. Dan quit the company, which eventually folded. But the idea of using cookies to track users survived.
Meanwhile, Dan figured that privacy would be the next big thing. In 2001, he launched a privacy software company called Permissus. His idea was to sell technology to businesses that could help them track their customers’ data as it traveled through their computer systems.

This was a self-fulfilling process, as jobs elsewhere were only paying so much because those other businesses had hired the same pay consultants, who told every client company that they should pay their executives enough to attract the best people, and therefore set off an ever-upward ratchet. All sense of due restraint seemed to vanish from the upper reaches of business, as executives came to misinterpret the rise in share prices due to a stock-market bubble as the result of their own talent, and worse, came to feel that extraordinarily high pay was their due because they saw so many other people among their social contacts and peer group making so much. Many bankers are still in this mindset, although executive pay outside the financial markets is gradually deflating.
The boom in the financial markets thus came to corrode social norms throughout the economy.

To top it all, a financial crisis, centred in the US but global in scope, began to unfold in the state–finance nexus that had powered suburbanisation and underpinned international development throughout the post-war period. This crisis gathered momentum at the end of the 1960s. The solution was becoming the problem. The Bretton Woods Agreement of 1944 came under stress. The US dollar was under mounting international pressure because of excessive borrowing. Then the whole capitalist system fell into a deep recession, led by the bursting of the global property market bubble in 1973. The dark days of the 1970s were upon us with all the consequences earlier outlined.
Fitting, though, that it was the New York City fiscal crisis of 1975 that centred the storm. With one of the largest public budgets at that time in the capitalist world, New York City, surrounded by sprawling affluent suburbs, went broke. The local solution, orchestrated by an uneasy alliance between state powers and financial institutions, pioneered the neoliberal ideological and practical political turn that was to be deployed worldwide in the struggle to perpetuate and consolidate capitalist class power.

Indeed, given that the federal expenditures in 1929 were only “about 2.5 percent of gross national product” this was hardly surprising.18 Such policies also seemed increasingly redundant by 1929. Because of the stock-market boom, unemployment had fallen to a postwar low.
Even though the state had limited its ambitions to balancing the budget and ensuring convertibility, because of the unexpected bursting of the stock market bubble, Hoover spent $1.5 billion on public works when he became president in 1929. By 1931, overall federal spending was up by a third from its 1929 level.19 Given how small state expenditures remained relative to GDP, however, the now-accelerating decline in private spending meant that tax “receipts dwindled by 50 percent and expenditure rose by almost 60 percent.”20 At this juncture Hoover saw austerity as the only way, and the right way, to restore “business confidence” and balance the budget.

In addition, any money that is used to repay government debt will be transferred to those institutions that were holding government bonds. Because most of these bonds were initially a form of savings, it is likely that this money will be put back into the financial markets (i.e. people won’t suddenly start spending money they had allocted as saving). Using newly-created money to pay down the national debt will pump this money into the financial markets, where it may stay circulating, fuelling financial market bubbles and doing little or nothing to help the real economy.
To avoid this, if it was thought desirable to reduce the nominal value of the debt, bonds should be removed from circulation over a period of time. Fund managers would be well aware that a portion of government bonds were being ‘phased out’, but would have around ten to fifteen years in which they could gradually shift their investments away from the bond market and into corporate bonds and the stock market.

To someone without much knowledge of history, it would appear that the world was shaken by a series of cataclysmic political and military events after 1973. Floating currencies became a source of instability for the international economic system rather than a safety valve.
Economists and policy makers would endlessly debate during the eighties and nineties whether currency values reflected fundamental economic conditions or simply distortions in foreign currency markets: bubbles, irrationality, myopic expectations, or short-term trading strategies. What do all these men in their twenties and thirties—they are mostly men—sitting in front of huge computer screens, who move hundreds of millions of dollars across the globe at a keystroke and determine the fate of nations’ currencies, really do? Do they serve to eliminate inefficiencies in the market and bring currency values closer to their true underlying economic worth?

But
that’s not what anyone pays for anymore. Their economies achieve
full employment, sure, but these countries are not economic powerhouses. Not anymore.
We were investing in companies with no more than 50–100
workers, most of them highly paid programmers and engineers,
whose occupational hazard is coming down off a caffeine buzz and
an occasional late night Nerf gun injury. Yet even after the market
bubble burst in 2000, these companies would still be worth more
than Ssangyong, a company a hundred or a thousand times their
size. The stock market values small businesses with high margins
over big businesses with low margins. Is that good or bad? Should
I even care?
Whenever I try to ﬁgure out why this is, I keep thinking back
and visualizing Mr. Shim, a walking, talking and sweating metaphor for how to invest.

After 1971, floating-rate systems appeared to be the answer. But a country that gives into the devaluation option too often under floating rates eventually suffers from higher inflation and interest rates. Creditors extort their revenge over the long term. The Europeans sought to escape this problem by clubbing together in a single currency, but eventually the strains had to show.
7
Blowing Bubbles
‘Stock market bubbles don’t grow out of thin air. They have a solid basis in reality, but reality as distorted by a misconception.’
George Soros, hedge fund manager
Where did all the money go? My father-in-law asked that question in the aftermath of the credit crunch of 2007 and 2008, when house prices, share prices and corporate bond prices all tumbled. It seemed a reasonable point. If all the assets in the world were worth, say, $3 trillion one year and $2 trillion the next, what happened to that missing trillion?

That burden steadily declines as the borrower’s income climbs along with inflation. Low inflation reduces the payment and enables the buyer to afford a much larger mortgage and thus a pricier house.
While it was true that high inflation was corrosive to financial stability, so, perversely, was low inflation: inflation was low and economic growth stable in the 1920s in America, and in 1980s-era Japan. In both cases, the result was a stock market bubble. Greenspan himself pointed this out in the aftermath of the dot-com bubble in 2002. As inflation had become tame, recessions had become less frequent, so investors and home buyers were willing to pay higher prices for assets, which exposed them to big losses if anything went wrong. “It seems ironic,” he said, “that a monetary policy that is successful in inducing stability may inadvertently be sowing the seeds of instability associated with asset bubbles.”

Wang Xing-Guo, the pro-liberalization governor of the People’s Bank of China, the central bank (granted full independence in 2017), summed up this optimism perfectly: ‘What are we afraid of? The money game is in our genes – after all, paper money is a Chinese invention!’ When it joined the organization in 2024, China revalued its currency, the renminbi, by four times and fully opened its capital market. For a while, the Chinese economy boomed as though the sky was the limit. But the resulting real estate and stock market bubbles burst in 2029, requiring the largest IMF rescue package in history.
Soaring unemployment and IMF-imposed cuts to government food subsidies led to riots and eventually to the rise of the Yuan-Gongchandang (Real Communist) movement, fuelled by the seething resentment of the ‘losers’ in a society that had moved from the near-absolute equality of Maoist communism to Brazilian-style inequality in the space of less than two generations.

Indeed, the two trends operate in tandem, with some rather bizarre consequences.
Financialization and shareholder capitalism perhaps represents the apogee of rationalized capitalism. Here, the numerical monetary logic of pure accumulation truly creates an inversion of ends and means that is shocking. Whatever it takes to increase shareholder value – firing staff, plundering the natural environment, creating extremely volatile property-market bubbles – must be pursued in a single-minded fashion, even if it harms the organization in question. Like all forms of hyper-rationalization, shareholder capitalism fosters a mentality that is generally antisocial and sometimes diabolical when observed from an outside perspective. For example, a large funeral home corporation in the United Kingdom recently had to break some bad news to its shareholders.

We had done some work, as part of my Ph.D. research, on the evolution of cooperation in small-world networks and on a special case of what is called a voter model (similar to the spiral-of-silence problem studied by Noelle-Neumann). But at the time, we hadn’t thought of either of these problems as related to contagion.
Now it seemed clear that contagion in a network was every bit as central to the outbreak of cooperation or the bursting of a market bubble as it was to an epidemic of disease. It just wasn’t the same kind of contagion. This point is particularly important because typically when we talk about social contagion problems, we use the language of disease. Thus, we speak of ideas as infectious, crime waves as epidemics, and market safeguards as building immunity against financial distress. As metaphors, there is nothing wrong with these descriptors—after all, they are part of the lexicon and often convey the general point vividly.

Next comes frenzy, when we see the formation of speculative bubbles, increasing unemployment, and the beginning of unrest. That’s likely where we are today, with the absurd valuation of every remotely plausible new platform monopoly, as well as the joblessness and upset that the successful ones generate: cabdrivers protesting Uber, hotel workers complaining about Airbnb, and San Francisco residents throwing rocks at Google buses over inflated rent prices.
Then the stock market bubble pops. Perez sees that as the turning point, when wealth disparity between the winners and losers reaches an extreme, civil unrest reaches a peak, and government is forced to act through regulation. For instance, the irruption and frenzy phases of automobiles and mass-produced appliances led to the Roaring Twenties and eventually the 1929 crash. So government and even industry begrudgingly supported the New Deal and the welfare state.

“I go out only a few nights per month, but on those nights, I tend to come home with two girls, or, usually, more.”
Woods takes a perverse pride in saying that he has not watched a horse race in person in the past eighteen years. He does not find horse races that interesting. Results arrive as instant messages from his agents at the track, punctuated by the appropriate smiling or frowning emoticons.
Near the top of the late 1990s stock market bubble, Woods sold short the NASDAQ index. It was an outright gamble that the bubble would burst, and the timing was wrong. Woods says he lost $100 million. “When you look at how much money I have consistently made from the horses, from 1987 onward, compared to what I’ve done in the market,” he said, “horses would seem to be a far safer investment than stocks.”
The Dark Side of Infinity
CLAUDE SHANNON DIED the same year as HAL—2001—on February 24.

But the network age, because of that chaos that travels with connection, makes the complicated complex. Complicated systems are packed with parts, but they are predictable. It’s the complex ones that really change the rules. And once a mesh of complex connection is really flowing, it produces surprising interaction. Precisely because there is no central plan, the best of these linked systems create, in a sense. From computer crashes to market bubbles. Castells’s social protests emerged in this complex way, appearing like condensate in the jar of the post-2008 economic crisis. Researchers following in his wake studied the Spanish anti-austerity movement of 2011 and found that it was composed largely of new organizations that blossomed from connectivity. Other Spanish protest groups, such as labor, anti-abortion activists, and regional separatists, relied on decades-old organizations.

This is seen when one calibrates a model to market prices of derivatives, without ever studying the statistics of the underlying process.
The validity of the EMH, whichever form, is of great importance because it determines whether anyone can outperform the market, or whether successful investing is all about luck. EMH does not require investors to behave rationally, only that in response to news or data there will be a sufficiently large random reaction that an excess profit cannot be made. Market bubbles, for example, do not invalidate EMH provided they cannot be exploited.
There have been many studies of the EMH, and the validity of its different forms. Many early studies concluded in favour of the weak form. Bond markets and large-capitalization stocks are thought to be highly efficient, smaller stocks less so. Because of different quality of information among investors and because of an emotional component, real estate is thought of as being quite inefficient.

Maybe they are right. One cannot decisively prove that the stock market has been irrational. But in all of this debate no one has offered any real evidence to think that the volatility is rational.6
The price changes appear instead to be correlated with social changes of various kinds. Andrei Shleifer and Sendhil Mullainathan have observed the changes in Merrill Lynch advertisements. Prior to the stock market bubble, in the early 1990s, Merrill Lynch was running advertisements showing a grandfather fishing with his grandson. The ad was captioned: “Maybe you should plan to grow rich slowly.” By the time the market had peaked around 2000, when investors were obviously very pleased with recent results, Merrill’s ads had changed dramatically. There was a picture of a computer chip shaped like a bull. The caption read: “Be Wired . . .

pages: 351words: 93,982

Leading From the Emerging Future: From Ego-System to Eco-System Economies
by
Otto Scharmer,
Katrin Kaufer

The two main sources of power at this stage are state-based coercive legal and military power (sticks) and market-based remunerative power (carrots). The great positive accomplishments of the laissez-faire free-market 2.0 economy and society are rapid growth and dynamism; the downside is that it has no means of dealing with the negative externalities that it produces. Examples include poor working conditions, prices of farm products that fall below the threshold of sustainability, and highly volatile currency exchange rates and stock market bubbles that destroy precious production capital.9
SOCIETY 3.0: ORGANIZING AROUND INTEREST GROUPS
Measures to correct the problems of Society 2.0 include the introduction of labor rights, social security legislation, environmental protection, protectionist measures for farmers, and federal reserve banks that protect the national currency, all of which are designed to do the same thing: limit the unfettered market mechanism in areas where the negative externalities are dysfunctional and unacceptable.

pages: 346words: 90,371

Rethinking the Economics of Land and Housing
by
Josh Ryan-Collins,
Toby Lloyd,
Laurie Macfarlane,
John Muellbauer

When an economic shock hits or interest rates rise, the economy is then faced with a situation where all sectors of the economy (apart from the government), led by households, seek to deleverage and reduce their debts – ‘rebuilding their balance sheets’ (Koo, 2011). Households reduce their spending and increase their savings, this reduces firms’ profits, leading them to pull back from investment and pay off their debts, and banks contract their lending and rebuild their capital base. A range of studies show that such balance sheet recessions tend to last longer and be deeper than crises that do not involve credit bubbles (e.g. stock market bubbles); and within the universe of recessions caused by credit bubbles, land-related credit bubbles are consistently deeper and last longer (Buyukkarabacak and Valev, 2006; Schularick and Taylor, 2009; Borio et al., 2011; Bezemer and Zhang, 2014; Jordà et al., 2015).
The clearest example of the long-term damage a land price credit bubble can do to an economy is Japan. In the lead-up the to the crash in 1991, there was excessive credit creation for real estate purchase, particularly in Japan’s fast growing cities, driving a self-reinforcing stock-market boom.

The paradox of social development—the tendency for development to generate the very forces that undermine it—means that bigger cores create bigger problems for themselves. It is all too familiar in our own age. The rise of international finance in the nineteenth century (CE) tied together capitalist nations in Europe and America and helped push social development upward faster than ever before, but this also made it possible for an American stock market bubble in 1929 to drag all these countries down; and the staggering increase in financial sophistication that helped push social development up in the last fifty years also made it possible for a new American bubble in 2008 to shake virtually the whole world to its foundations.
This is an alarming conclusion, but we can also derive a third, more optimistic, point from the troubled history of these early states.

…

Fleeing Europe’s contagious rivalries and wars, American politicians left the conductor’s podium empty, withdrawing into political isolation worthy of eighteenth-century China or Japan. While times were good the orchestra improvised and muddled through, but when they turned bad its music became cacophony.
In October 1929 a little bungling, a lot of bad luck, and the absence of a conductor turned an American stock market bubble into an international financial disaster. Contagion raced through the capitalist world: banks folded, credit evaporated, and currencies collapsed. Few starved, but by Christmas 1932 one American worker in four was jobless. In Germany it was closer to one in two. Lines of the gray-faced unemployed stretched out, “gazing at their destiny with the same sort of dumb amazement as animals in a trap,” the English journalist George Orwell thought.

pages: 1,009words: 329,520

The Last Tycoons: The Secret History of Lazard Frères & Co.
by
William D. Cohan

That's why Monnet was always my role model. He was never a member of government. He never held a cabinet position. He never ran for office."
Such an extraordinary comparison of an investment banker to a man of great political and economic accomplishment is simply not conceivable today (with the possible, ironic exception of Bob Rubin). Felix alone compares favorably. The aftereffects of the collapsing stock market bubble and the plethora of corporate scandals have left many observers believing that bankers are self-interested and greedy rather than purveyors of independent advice. "Investment bankers, as a class, are the Ernest Hemingways of bullshit," explained one well-known private-equity investor. Felix had few peers in the days when offering CEOs strategic wisdom was the metier of a select handful; he has none now that it is the medium of the many.

…

But regardless of the fund's future performance, Steve was again front-page news. By setting up his own $1 billion fund, Steve--by then one of the Democratic Party's biggest fund-raisers--had taken himself out of the running to be in Gore's cabinet, should the vice president have won the presidency in 2000. With their shocking departure, all four partners' Class A percentage interests were thrown back into the pool for future reallocation.
The bursting of the market bubble on March 10, 2000, when the Nasdaq peaked intraday at 5,132, had a grave impact on Wall Street. Tens of thousands of investment bankers lost their jobs, and the compensation for those who remained was much diminished. Eliot Spitzer, the ambitious New York state attorney general (now governor), orchestrated the $1.4 billion Wall Street research settlement, and prosecutors began the steady stream of indictments of corporate executives from, among others, Enron, WorldCom, Adelphia, and HealthSouth.

This requires nerves of steel and runs the risk that you may exhaust your cash long before the market finally touches bottom. I don’t recommend this course of action to all but the hardiest and experienced of souls. If you decide to go this route, you should increase your stock allocation only by very small amounts—say by 5% after a fall of 25% in prices—so as to avoid running out of cash and risking complete demoralization in the event of a 1930s-style bear market.
Bubbles and Busts: Summing Up
In the last two chapters, I hope that I’ve accomplished four things.
First, I hope I’ve told a good yarn. An appreciation of manias and crashes should be part of every educated person’s body of historical